Tax Implications Converting 1031 Rental to Primary Residence

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Many questions are asked regarding converting a rental property acquired in a 1031 exchange into a primary residence. How long does the rental property need to be held? How long does the property need to be held to qualify for the exclusion as a primary residence?

Revenue Procedure 2008-16

Revenue Procedure 2008-16 defines the hold time of a rental property must be two years. In each of the two years the property must be rented out to non family 14 overnights per year and personal use is limited to no greater than 14 overnights or 10% of the time rented.  The two years is one fact of many that supports the intent to qualify the property as a 1031 exchange replacement property.

When the property is acquired, there can be no concrete intent to convert the property to your primary residence. Review Goolsby v. Commissioner for insight on what not to do.

Conversion

Converting the character of the rental property is accomplished by moving in, changing your Driver's License, post office and Voter Registrations' addresses to reflect the new property address. Consider selling your old primary residence and given you were living there for two years benefit from the exclusion of $250,000 if filing single or $500,000 if filing joint. Or convert the property to a rental property.

Tax Implications

Converting rental property acquired in a 1031 exchange to a primary residence blends Section 1031 with Section 121 that provides the $250,000/$500,000 exclusions. To benefit from Section 121, the converted property must be held for five years with the first two as a rental also known as non qualified use. At the end of five years, 3/5 of the gain is excluded given the $250,000 or $500,000 limits in Section 121.

• For example, the rental property was acquired after January 1, 2009 and held for two years as a rental property to qualify the replacement property for the second leg of the 1031 exchange.
• If acquired before January 1, 2009, non qualified use is not included in calculating non qualified use, though is included in determining total years of ownership.
• The property was converted to a primary residence January 1, 2011 and sold January 1, 2014 for a realized gain of $200,000. Two years out of five, held as a rental or $80,000 is ineligible while 3/5 (three out of the five years) of the gain or $120,000 is excluded or absorbed by the $250,000/$500,000 exclusion.
• Recaptured depreciation is not eligible for the exclusion and is recaptured at 25% of the aggregate depreciation taken on Schedule E.

Conclusion

Converting a rental property acquired in a 1031 exchange into a primary residence and following the rules qualifies the taxpayer to eliminate the gain that does not exceed the exclusion representing a huge benefit.

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