One of the biggest questions we get is: “can I use my primary residence in a 1031 tax-deferred exchange?” Well, maybe not everyone, but certainly some. But, can you? The IRS’ short answer is a stern no. However, as is usually the case under the Internal Revenue Code, there are exceptions.
Consider this scenario: what if you decide to turn your primary residence into a rental property? Now we’re getting somewhere. If you convert your primary residence into a rental property (i.e., you are, in fact, renting it to tenants who have possession, and you no longer personally occupy the property), you may use it in a 1031 exchange. Although the tax code doesn’t state exactly how long you must hold the property for rental purposes, most tax professionals agree that one to two years is long enough, provided you can demonstrate the property is used for business or investment purposes. The IRS is clear on two points:
Merely declaring your house is a rental property isn’t enough.
You can’t live in your house at all while it’s a rental property, and you must actually rent it out for some period of time.
All right, so you’ve established that your property is no longer your primary residence, but a rental property. Now you can do a 1031 exchange and defer all of the capital gains from a sale of that property. Because remember, when done correctly, a 1031 exchange allows you to defer 100 percent of the capital gains taxes on the sale of real estate. (To learn how a 1031 exchange works, click here.)
Utilizing a Section 121 Exclusion
Although converting your primary residence into an investment property and then conducting a 1031 exchange is a great option, what if you don’t have the time or resources to do so? Does the IRS give any leeway on capital gains taxes if you decide to sell your primary residence outright? The answer is yes, and is completed through a Section 121 exclusion. The Section 121 exclusion isn’t a tax deferment method like a 1031, however. Instead, it is used for gains exclusion on your primary residence when you decide to sell. Single filers can exclude up to $250,000 of gains on the income from the sale of their primary residence. Those filing jointly can exclude up to $500,000.
To take advantage of section 121, you need to have lived in the home for two of the last five years. Those 24 months do not need to be contiguous. The IRS allows you to aggregate time lived in the home during a five-year span to meet the two-year requirement. The exclusion can be claimed once every two years.
And now you know: your primary residence may not be used in an exchange—but if you make it your former residence and hold onto it as an investment, you are free to proceed with one. If converting your primary residence into an investment property isn’t feasible, however, you may be eligible to take a Section 121 exclusion, which may mitigate some of the tax hit. So while rules (especially those created by the IRS) are not meant to be broken, spotlighting the exceptions can make a big difference for your investment portfolio.
If you are considering a 1031 exchange, contact us to discuss your questions, concerns, and needs. Realized would love to help reduce the risk, time, costs, and complexity of completing your exchange. Give us a call at 877-797-1031 or email us at firstname.lastname@example.org.
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