Understanding the 1031 Exchange Five-Year Rule

In most cases, you can’t use a 1031 exchange to defer capital gains taxes and depreciation recapture on primary residence sales. This is because primary residences don’t fall under the category of real estate used for investment or business purposes. 

However, it is possible to exchange that property if you initially acquired it through a 1031 exchange as an investment property and want to sell it later as a primary residence. Thanks to the American Jobs Creation Act of 2004, you could accomplish that sale through the five-year rule.

Proper execution of the five-year rule could let you take advantage of the IRC Section 121–”Exclusion of Gain from Sale of Principal Residence.” This legislation permits you to exclude up to $250,000 of capital gains from the sale of that residence (or $500,000 if you’re filing jointly). However, the exclusion only applies to the portion of the gain attributed to the period when the property was used as a primary residence. Any gain from the prior investment period remains taxable.

Requirements of the Five-Year Rule

One mandate of the five-year rule is that you must own the property in question for at least five years. This process requires a few other rules:

• While no strict IRS rule requires a rental time period, many tax professionals recommend at least two years of rental use to support investment intent. Satisfying this requirement demonstrates that the property was held for investment purposes.
• You must use the property as your primary residence for at least two years. This action fulfills the Section 121 requirements.
• You must file for the exclusion within the same tax year you sell the property.

Failure to follow the requirements means you could be liable for capital gains taxes and depreciation recapture from the previous exchange. Noncompliance could also reduce your credibility. As a result, any 1031 exchange you attempt in the future might raise red flags with the IRS.

Best Practices: Ensuring Compliance with the Five-Year Rule

Consider the following if you’re thinking about converting your exchange investment property into a primary residence in accordance with the five-year rule:

• Know the requirements: Before taking this course of action, be sure you understand the rules and mandates involved with Section 121 and the five-year rule.
• Plan ahead: Map out your investment goals and create a timeline. This can help you follow the required timing for investment and primary residence usage.
• Work with professionals: The 1031 exchange process is already complex, and adding additional activities can lead to more confusion. Partnering with your tax advisor and other experts provides guidance and resources to assist you with the process.

In summary, combining the 1031 exchange process with Section 121 advantages is possible. In such a situation, adhering to the five-year rule is required. When appropriately used, this approach can help improve your tax-advantaged strategy while moving you toward your investment goals.

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.