In a recent article, we answered the question about whether a triple-net (NNN) lease investor can use a 1031 exchange for new construction, to which the answer is yes, with conditions. In this week’s post, we’ll cover another 1031 question we get asked often, “Can I sell my primary residence and use a 1031 exchange to buy a commercial NNN property?”
This answer to this is less straightforward. However, when structured intentionally, a 1031 exchange can be used with personal property if you’re willing to plan ahead and follow the special Section 121 rules.
1031 Exchange Deferral vs. Section 121 Exemption
A standard 1031 exchange allows investors to defer capital gains taxes on the profits from the sale of an investment property when the profits are reinvested into another like-kind, commercial property.
Typically, the IRS excludes a 1031 exchange on a primary residence since it is not a commercial property or considered like-kind. However, Section 121 of the Internal Revenue Code (IRC) provides for some situations in which a 1031 exchange on a primary residence is allowed.
Where section 1031 gives you a tax deferral on the payment of capital gains tax, Section 121 grants you a tax exclusion of $250,000 of gain for single filers and $500,000 of gain for married taxpayers filing jointly.
Section 121 requirements state that the profits from the sale of a personal residence can be exempt from capital gains tax if an investor has owned the property for at least five years, lived in it for two out of those five years, and rented it at fair market value for two years.
To sell a “primary residence” in a 1031 and use Section 121, the property has to stop being your primary residence and follow these rules:
- First, you must own your primary residence for at least five years and live in it for two of those five (does not have to be consecutive).
- Then, you must move out and rent the property for a minimum of 2 years.
- When you sell and utilize the 1031 to buy a NNN property, you must show that you don’t currently live at the property.
- You must prove that you’ve been using the property for business purposes.
- You must show the IRS that you leased the property at market rate.
Can I Convert a Rental Property to a Primary Residence Using a 1031 Exchange?
Another way to manage a 1031 exchange on a personal residence is to do the reverse of the previously explained situation. The IRS allows you to convert a property that was previously used as a rental into a primary residence and carry out a 1031 exchange.
For example, if you acquired the rental investment as a replacement property in a previous exchange, then you can use a Section 121 to convert it into your primary residence. To make this work, you must show that you have not lived in the property for more than 14 days out of every 12 month period and that the property has been rented out for at least 24 months. This is called “qualified use,” and for many investors, this is often a secondary, vacation home that is rented out while they live in their primary residence for most of the year. It can also apply to properties used as Airbnb rentals.
Just as before, you will need to prove to the IRS that the property was leased at the market rate. Additionally, you are not allowed to make any custom changes or upgrades to the rental that are for your personal use during the rental period.
To Wrap It Up – Plan Ahead for a Primary Residence 1031 Exchange
A single-family home, a multi-family property where you live in one unit and rent the other units out, or an investment property that is used as a short-term rental can all be used in a 1031 exchange or Section 121, but you must plan ahead so you fulfill all the IRS’s requirements.
If you should want to perform a 1031 exchange on a primary residence to acquire a NNN lease property, it is a complicated investment strategy. However, if you start working with an experienced Westwood Net Lease Buyer’s Advisor before you make any decisions and have help along the way, you can find success. Our advisors have decades of experience and specialize in assisting buyers with NNN lease and 1031 exchange transactions, at no cost to the buyer. Be sure to contact us today for your free, no-obligation consultation, 314-997-5227.
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