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Section 1031 Exchange: Converting Rental to a Primary Residence

 

Converting Rental to a Primary ResidenceUnder the normal Internal Revenue Service, or IRS, code regulations you are required to pay capital gains taxes when you sell a property and realize a profit. Although the rate at which capital gains are taxed fluctuates, it is typically rather high given federal, possibly state capital gains and recaptured depreciation taxes. This tax can quickly eat away at the gain you realized on the sale of an investment. One option that allows you to defer the payment of capital gains taxes is to enter into a Section 1031 exchange instead of a traditional sale. In some limited circumstances, converting a rental to a primary residence after the exchange has been completed may be allowed eliminating the majority of the gain via the $500,000/$250,000 exclusion.

IRS Code Section 1031

In pertinent part, the Section 1031 Exchange rules read “Section 1031(a) provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind that is to be held either for productive use in a trade or business or for investment”. In other words, if you exchange one rental property for another, it will qualify for deferral of the capital gains taxes as long as all other Section 1031 requirements are met. But what if you later wish to convert the rental property that you acquired in the exchange to your primary residence?

IRS Case Analysis

The intent of the purchaser at the time of the exchange is paramount in determining whether the property will qualify for Section 1031 treatment. In Goolsby v. Commissioner, TC Memo 2010-64 (April 1, 2010), the purchaser exchanged one rental property for another. The purchaser did advertise the acquired property for rent for two months in a local newspaper, but failed to ascertain whether the neighborhood association would allow the property to be rented. Gooslby and his family moved into the property less than two months after the transaction was completed. In addition, Goolsby made the purchase of the property in question contingent upon the sale of his current primary residence located in another state. The transaction was not allowed to receive Section 1031 treatment.

In contrast to Gooslby, consider how Reesink v. Commissioner, TC Memo 2012-118 (April 23, 2012) was analyzed. In Reesink, the purchaser acquired a single family home which he immediately advertised for rent via flyers around the area and signs posted at the property. At least two prospective tenants visited the property but ultimately decided that the monthly rent was out of their price range. At the time the exchange was entered into, Reesink owned another property that was the family’s primary residence. The primary residence was located in another city. After approximately six months, the rental property was still vacant. Because of financial concerns, Reesnik eventually sold his primary residence and the family moved into the rental property. The transaction was distinguished from Goolsby because it was clear that the purchaser owned another primary residence at the time of the transaction, attempted to rent the property for six months before moving in, and only made the conversion to a primary residence out of financial need almost seven months after the transaction was completed.

The outcome of these two decisions provides some guidance regarding good supporting facts for converting a rental property to personal use after acquiring the property in a 1031 exchange. If you have questions, contact our office for clarification by clicking on the button below.

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