There may come a time when you want to turn an investment rental property acquired through a 1031 exchange into a primary residence. While the process is usually not complicated, converting real estate assets acquired through a like-kind exchange could pose several challenges. The IRS has strict rules regarding the use of such assets. Failure to comply could result in the loss of your tax-deferred status.
Why Convert?
There are a few reasons why you might want to convert your investment rental property into a primary residence:
As an exit strategy. Being a landlord has multiple perks–and multiple headaches. One way to leave those headaches behind is by changing your property’s purposes from investment to residence.
As a tax-advantaged strategy. You might convert that rental property to leverage potential tax benefits without resorting to a 1031 exchange. Through this process, you could take advantage of possible tax advantages offered through the Section 121 Exclusion.
Understanding IRC Tax-Advantage Regulations
The Internal Revenue Code generally has two sections that can provide possible tax benefits while impacting rental-to-primary-use conversions: Section 121 and Section 1031.
Section 121: Primary Residence Sale and Capital Gains
Through Section 121, you could exclude part of what you earn by selling your primary residence from capital gains taxes. The amount is $250,000 for single tax filers and $500,000 for married couples.
Section 121 also has must-follow rules for this capital gains exclusion. Specifically:
- Ownership test: You must have owned the home for at least two out of the five years before selling it
- Use test: You must have lived in the home as your primary residence for at least two out of the five years before the sale
Here’s an example of how Section 121 might operate:
- You buy a house as a primary residence in January 2019 and live there until January 2022.
- You relocate to a different state, rent the house out until 2024, and then sell it to the renters.
- You could qualify for the tax exclusion because you owned the house for five years and lived in it for three years.
Section 1031: Capital Gains Deferral on an Investment Property Sale
The like-kind exchange is one way for you to potentially defer capital gains on the sale of investment property (the relinquished property) by exchanging it into like-kind property or properties of equal or greater value (the replacement property).
Specific stipulations for a successful like-kind exchange include in-stone deadlines and using a Qualified Intermediary (QI) to handle the funds.
One major requirement for the replacement property is that it be held for business or investment use. That property can’t be used for your primary residence. This requirement can cause complications if you want to convert that rental property into your main residence.
Rules of Conversion
Converting an investment property obtained through a 1031 exchange into a primary residence that could potentially benefit from a Section 121 exclusion requires patience and the following steps:
#1–Hold the Property for Investment
After acquiring the replacement property, you must demonstrate your intent to hold it for business or investment purposes. Some ways to demonstrate intent include: rental agreements, improvements, marketing and advertising, and the length of time you own the asset.
The IRS doesn’t have strict requirements for the holding period. However, most experts suggest you own the replacement property for at least two years to decrease the chances of unwanted IRS attention.
#2–Gradually Take Steps to Live in the Property
Following the holding period, you may convert the property as your primary residence. Once that asset is your primary residence, you must own it for at least five years and live in it for a minimum of two years.
Additional Tips
A conversion means you’ll need to navigate several tax implications and limitations. One such implication–intent for investment use–was mentioned above. Additionally, planning for a rental property conversion should be something to consider way ahead in your investment horizon, especially given the length of the required hold time.
Other tips that can help with a conversion include the following.
Discussions about Conversion
Your goal is to demonstrate that the replacement property will be used for investment or business. IRS scrutiny may increase if there is clear evidence of a predetermined plan to convert the property for personal use.
Reconsider Renovations
In preparation for conversion, you might want to add a swimming pool or a landscaped garden to your property. However, these renovations could be viewed as red flags to the IRS. While owning the asset for investment purposes, be sure that any renovations are done to keep the property up to code and habitable for the tenants.
Ensure Integrity and Validity
Remain in compliance with any HOA rules and municipal, state, and federal regulations concerning rental properties. Doing so demonstrates an intent to use the property for business or investment purposes. It also could lower the chances of an IRS investigation when you begin conversion.
Work with Professionals
Even an experienced investor may not have all the knowledge needed to successfully navigate this type of conversion. Working with a tax attorney or 1031 experts is a best practice.
Maintain Proper Records
Proper documentation can offer protection against losing your tax-deferred status. Showing the IRS your rental agreements, financial records, and marketing materials can demonstrate your intent to hold the property for investment or business use.
Conversions, Taxes, and Following the Rules
Converting a rental property into your primary residence can be long and complicated, especially if you acquired the asset through a 1031 exchange. However, such a conversion can be successful as long as you have patience, plan ahead, document everything, and follow Section 121 and Section 1031 stipulations.
For additional assistance, contact the professionals at Realized 1031. The team has years of experience in all varieties of 1031 exchanges and can help guide you to the process that meets your investment goals. To schedule a no-obligation appointment, visit the website at realized1031.com.
Examples are used for illustrative purposes only.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
