1031 Exchange 5-Year Rule: What You Need to Know

1031 exchanges offer a potentially valuable tool for investors to defer payment of capital gains taxes when selling appreciated assets, as long as they reinvest the proceeds into a "like-kind" asset. Successfully executing a 1031 exchange to dispose of an appreciated property and replace it with another can be a financial advantage for investors.

The IRS governs the qualification for eligibility using specific timelines and a requirement that taxpayers do not have access to the sale proceeds while preparing for the replacement property purchase. The tool offers a deferral of capital gains taxes, which will need to be paid later if the investor sells the replacement property without using a 1031 exchange again.

Separately, taxpayers can exclude long-term capital gains from taxable income when they sell their primary residence under certain circumstances.

The 1031 exchange is designed for use with investment property or real estate used in a business, not for personal residential property. However, it's possible for a residential unit to change from investment to personal use and back. The IRS understands this and allows investors and homeowners, in some cases, to use the exchange deferral and the primary residence exclusion at different times but for the same property.

Deferral or exclusion?

The capital gains exemption for homeowners has seen numerous changes over the decades. There have been age requirements and the need to buy another home in the past, but these stipulations are no longer valid. Now, any taxpayer can exclude up to $250,000 in appreciation when they sell a primary residence (the limit is $500,000 for a married couple filing a joint tax return). To qualify, the taxpayer must meet these conditions:

1. You must have owned and occupied the property for two of the most recent five years. However, the ownership and occupancy do not have to be simultaneous. It’s possible that you could qualify by living in the home before the purchase, but in most cases, people are selling a current residence.
2. You can use the exemption no more than every two years. This stipulation means that if you have two homes for which you can demonstrate the ownership and occupancy requirements, you can only claim an exemption when selling once within two years.

What happens if I convert an investment into a residence?

Suppose you buy a rental property and rent it to others for two years, then move in and occupy the home for two years. You will qualify for the exclusion of capital gains. You would not need to extend the occupancy further.

However, suppose that you acquired the rental using a 1031 exchange. To maintain the eligibility of that purchase for the tax deferral, you must use the property as an investment for two years (a shorter period might qualify, but two years is considered a safe harbor). After those two years, you can convert the residence to personal use without risking disqualification of the previously granted 1031 exchange benefit.

In this case, you must own the property for a total of at least five years if you want to exclude the capital gains when you sell it as a primary residence. The ownership period can be divided into a portion of personal and rental use, with at least two years for each usage.