“Can you use a 1031 exchange for your primary residence?" is a common query among homeowners. However, the simple answer, according to IRS guidelines, is 'no.' A primary residence does not meet the 'held for productive use in a trade or business or for investment' requirement stipulated by IRC Section 1031, which forms the foundation of a tax-deferred exchange. The purpose of a 1031 exchange is primarily to defer capital gains taxes on investment properties. Yet, it's worth noting that certain exceptions exist within the Internal Revenue Code, adding layers of complexity to this seemingly straightforward ruling.
When are capital gains taxes imposed?
The IRS imposes capital gains taxes on the appreciation of assets, including personal property and investments. However, one of the crucial elements of capital gains taxes is that the taxpayer only owes them when they realize the gain.
For example, if you bought stock in Amazon 25 years ago, you might have obtained it for less than $3 per share. Suppose you purchased 1000 shares for $2.67 per share at the end of the year. Today, that stock sells for $103.62, a difference per share of $100.95. The increase in value for your 1000 shares is over $100,000. However, you don't owe taxes on the gain if you don't sell the shares. These unrealized gains are sometimes called “paper gains.”
The same rule applies to property: if you buy commercial property that increases in value but continue to hold the asset, you don't owe taxes. When you sell the property, you owe capital gains taxes if the value has increased. This timing applies to both personal and investment property.
What is the difference between deferral and exclusion?
You owe capital gains taxes on any appreciation when you sell your primary residence. Suppose you bought your home along with that Amazon stock in 1998 and decided to sell it in 2023. During that 25-year period, the value of your residence likely went up and down, but in the end might be valued at 800% or more of the original purchase price, leaving you with a significant tax bill.
However, the IRS allows an exclusion from capital gains taxes for a personal residence (as long as you have owned and lived in the property for at least two of the last five years and have not claimed the exemption for another primary residence in the most recent two years). Individual taxpayers can exclude up to $250,000 in gains, while married taxpayers filing jointly have a $500,000 exemption.
In contrast, the 1031 exchange is a tool you can use to defer the capital gains taxes on an investment property. By reinvesting the proceeds from the sale into a “like-kind” property (also an investment), you can defer the realization of the taxes due. The deferral lasts until you later sell the replacement property without executing another 1031 exchange, or you distribute the asset to an heir.
How can I defer capital gains taxes on my primary residence?
There are two potential ways to include a primary residence in a 1031 exchange transaction. First, you can transition your primary residence into an investment property and then sell it, allowing you to use it in the 1031 exchange. The best way to complete this transition is to live elsewhere and use the former residence as a rental for two years.
However, suppose you own a duplex. If you live in one unit and rent the other unit at fair market value, you could sell the duplex and use both the primary residence exclusion and the 1031 exchange deferral. The unit you occupy qualifies for the exclusion, while the sale price allocated to the other unit can be used in a 1031 exchange. This combination transaction would be complex, so ensure that you seek professional guidance.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
