The character of a 1031 exchange property or primary residence can always be converted between personal and rental use. A property acquired as a rental property in a 1031 exchange can be converted to a primary residence by the facts that support the intent. Time is one fact of many, while additional supportive facts include where children attend school, where mail is received and the address registered with the local voting authorities.
In the current economic malaise, many vacation home owners are converting their vacation homes to primary residences. Owners of multi-family units are occupying one of their units and either renting out the primary home or selling to take advantage of the tax free gain provided by IRS Code Section 121, which allows exclusions of $250,000 and $500,000 for single and married returns respectively. As long as no other primary home has been sold in the prior two years, the taxpayer can rent a property and have up to two years to sell their primary residence to utilize the Section 121 exclusion.
Tax Consequences of Selling a 1031 Rental Converted to a Primary
When a 1031 exchange primary residence is held as a 1031 rental, and then converted to a primary residence and sold, the tax consequences are a blend of IRC Section 1031 and Section 121. For example, if a rental was acquired as replacement property in a previous 1031 exchange and then converted to a primary residence and held for an additional three years, or total of five years, 3/5ths of the realized gain is excludable under the Section 121 limits. The rental 2/5ths is considered “non-qualified use” and is ineligible for the exclusion. The longer the property is held as a primary residence before selling, the greater the realized gain that can be excluded.
In a 1031 exchange, the recognized gain or tax is deferred. The tax obligation does not go away, but rather the realized gain of the original property reduces the realized gain of the replacement property. When the new property is sold, the recognized gain is the sum of the realized gain from the two properties. To understand how realized and recognized gain are determined, review Three Steps to Tax Deferred Formula.
Can the rental property be converted to a 1031 exchange primary residence earlier than two years? The answer is yes, though to satisfy Revenue Procedure 2008-16 so the Internal Revenue Service will not challenge whether the property is viewed as a rental property, the property should be held for two years post purchase as a rental. In each of those two years, the property should be rented at least fourteen overnights per year at fair market rent.
Related article discussing the tax consequences are:
- Tax Implications of Converting a 1031 Rental to Primary Residence
- Tax Implications of Selling a Converted Primary Residence to a Rental
Are you considering selling a rental property and don’t want to acquire a replacement property? If so, consider a Deferred Sales Trust that allows the capital gain tax to be deferred indefinitely.