What is a 1031 Exchange?
A standard 1031 exchange allows investors to defer capital gains taxes on the sale of an investment property, which provides tremendous tax savings for investors. It also makes it easier to use leverage to upgrade to a larger or better-performing property. This is a great investment strategy to diversify your portfolio with a different type of investment property or to simply choose properties that are easier to manage, like triple net lease properties.
However, when structured intentionally, a 1031 exchange can be done on personal properties, including one method savvy investors can use to legally defer federal capital gains taxes on a personal residence.
How to Perform a 1031 Exchange on a Personal Residence
Typically the IRS excludes a 1031 exchange on a primary residence since it is not a commercial property. However, Section 121 of the Internal Revenue Code (IRC) provides some situations in which a 1031 exchange on a primary residence could be conducted. Here’s how it works.
Can I live in a 1031 Exchange Property?
You cannot be living in a 1031 exchange property at the time of the exchange. Let’s clarify that.
Section 121 of the IRC states that a personal residence can be exempt from capital gains tax through a 1031 exchange if an investor has owned the property for at least five years and lived in it for two out of those five years. To be eligible for the exchange, you must be able to show the IRS that you rented out the property at market rate and actively prove that you lived elsewhere while using the property for business purposes.
Example of How to Perform a 1031 on a Primary Residence
Currently, you can take a $250/$500k gain as a tax-free gain on the sale of a former primary residence (be sure to consult your tax specialist or CPA for details pertaining to your situation). Any gain above and beyond that number would be taxable, so performing a 1031 exchange would defer those capital gains taxes. This is a fairly technical concept, so here is an example.
- I own five units in an apartment complex and lived in one unit for two of the five years.
- I paid $1M for the property ($200k for each unit) and eventually sold the complex after five years for $2M ($400k for each unit).
- I could completely avoid paying taxes on the unit I used as a primary residence as it is below the $500k threshold ($400k) but could perform a 1031 for the remaining $1.6M, as long as I purchase other investment properties with the profits.
A nice trick you can use if you own more than one residence is to live in one residence for a period of time, and then move to the second one, renting out the first one. Because the IRS lets you have only one primary residence at a time, you are able to do this as long as you can prove that your primary residence has changed. The first residence can then be converted to a rental property.
You Can Convert a Rental Property or Vacation Home 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. To make this work, you must show that you have not lived in the property for more than fourteen 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, often applies to a secondary vacation home that is rented out while the owners live in the primary residence for most of the year. It can also apply to properties used as Airbnb or Vrbo rentals.
To do this, you will need to prove to the IRS that the property was rented out at the market rate. This could mean advertising the property and retaining proof of what the going prices were for a similar property. Also, you are not allowed to make any custom changes to the rental that are for your use during this time period.
1031 Exchange Timelines
Before commencing with the 1031 process, it is advisable to already know your replacement properties and have chosen your qualified intermediary so that you don’t end up in a time crunch. The IRS only gives you 45 days from the minute you close on the original property sale to either complete the purchase of a new property or legally identify the new property you intend to purchase as part of your 1031 exchange.
You must complete your 1031 exchange within 180 days of selling your old property by purchasing one or more of the properties on your list. If you choose more than three properties, they cannot exceed 200% of the value of your old property. You cannot buy property as part of the exchange that is not on the 45-day list.
How Long to Identify 1031 Exchange
- You have 45 days after you sell the old property to identify or buy the new property or properties you intend to purchase.
- You must own your new property within 180 days of the sale of the old property or by the due date for your tax return for the year in which the transfer of the old property takes place, whichever arrives first.
- The exchange must be completed in 180 days total, not 45 days plus 180 days.
To Wrap it Up – Performing a 1031 Exchange on Primary Residence
Performing 1031 exchange on a primary residence converted to a rental or vice-versa is a great investment strategy, but also a complicated endeavor. This is why it’s highly recommended you assemble your team of professional advisors from Westwood Net Lease Advisors.
We specialize in 1031 exchanges and can help you with the entire process from planning to closing and thereafter. Our clients have had great success trading high-maintenance and costly rentals for triple net lease properties while deferring 100% of the federal capital gains taxes. Our buyer representation is free. Be sure to contact us today for a no-obligation conversation, 314-997-5227.