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1031 Exchange for Primary Residences

May 28, 2024

According to the IRS, both the relinquished and replacement property in a 1031 exchange must be held for investment or business purposes to qualify for tax deferral. This means that primary residences are not eligible for tax-deferred exchanges. However, you can still convert a primary residence to an eligible property for a 1031 exchange if you understand and adhere to the rules. These rules can be challenging to navigate sometimes; hence, you need an experienced QI to ensure you have a successful exchange.

With over 30 years of hands-on experience, our expert qualified intermediaries at Universal Pacific 1031 exchange have the required expertise to make your property conversion easy and compliant. We’re committed to guiding you through every step of the exchange to make sure you comply with all necessary regulations while having a smooth exchange. Schedule a free consultation with us today to get started.

In this guide, you’ll learn the step-by-step process of converting a primary residence to an eligible property for a 1031 exchange.

What Is a 1031 Exchange?

What Is a 1031 Exchange?

A 1031 exchange is one of the possible tax loopholes for real estate investors. It is a tax deferral strategy that allows real estate investors to defer capital gains taxes when they exchange one investment property for another like-kind property. The 1031 exchange process is regulated by Section 1031 of the Internal Revenue Code.

Note that a 1031 exchange is not necessarily a strategy to evade taxes. Tax evasion remains an illegal act and may attract severe legal consequences. A 1031 exchange essentially postpones capital gains taxes rather than evades them.

To successfully defer capital gains taxes, you must adhere to the strict rules specified by the Internal Revenue Service (IRS). For example, both the relinquished property and the replacement property must be like-kind. Moreover, you have to complete the 1031 exchange process within the IRS timeline of 180 days. First, you’re required to identify potential replacement properties within 45 days after the relinquished property sale. Secondly, you must complete the replacement property purchase within the remaining 135 days.

One of the most important requirements for a successful 1031 exchange is the investment intent or property use. According to the IRS, both the relinquished and replacement properties must be held for business or investment purposes. This simply means that only investment properties qualify for a 1031 exchange.

What Is an Investment Property?

An investment property is a real estate property that was acquired with the aim of earning income. The income may be through rent, resale of the property, or both. Such properties can be owned by an individual, a corporation, or a group of investors. Examples of investment properties include real estate properties such as undeveloped land, residential buildings such as family apartments, commercial properties such as warehouse and office spaces, industrial properties such as factories, and mixed-use properties such as residential buildings with units of retail stores.

Can You 1031 Exchange a Primary Residence?

Can You 1031 Exchange a Primary Residence?

No, a primary residence generally does not qualify for a 1031 exchange under the U.S. tax code. The IRS specifies that only properties held for business or investment uses qualify for a tax-deferred exchange. A personal residence does not meet this condition; hence, they do not qualify.

However, your primary residence may still qualify for a 1031 exchange under some conditions. If part of your home is rented out or used only for business, that portion of it may qualify for a 1031 exchange, as long as it meets other requirements of a tax-deferred exchange. For example, say you have a personal residence comprising four units of 3-bedroom apartments. If you live in one of the units and rent out the other three, that rented portion may be eligible for tax deferral when you sell the property as part of a 1031 exchange.

For individuals looking to benefit from tax deferrals on a primary residence, other provisions in the tax code may be applicable, such as the Section 121 exclusion. This allows you to exclude up to $250,000 (or $500,000 for married taxpayers filing jointly) of capital gains on the sale of your primary residence, provided you have lived in the home for at least two of the last five years before the sale.

How To Convert a Primary Residence Into a Qualified Property for 1031 Exchange?

How To Convert a Primary Residence Into a Qualified Property for 1031 Exchange?

It is possible to convert your personal property to a 1031 exchange property and defer capital gains taxes when you sell them in a 1031 exchange. The conversion process primarily aims to change the use of the property from principal residence to investment or business use. Below is a summary of the steps you can take to convert your primary residence to an investment property.

  1. Start by renting out the property at a fair market rate to demonstrate that you’re using the property for business purposes. It’s advisable to rent the property out for a relatively long time as short-term or intermittent renting may not qualify.
  2. Be sure to document all the rental activities in detail. Keep record of the lease agreements, rent receipts, and any relevant communication with your tenants. You’ll need these records to prove the investment use of the property to the IRS.
  3. Make sure you file the IRS Form 1040 Schedule E to report your rental income and expenses. This serves as an official declaration that your property is an investment rather than a primary residence. In addition, find out and fulfill other tax requirements for investment properties.
  4. Observe the safe-harbor rule. Under the Revenue Procedure 2008-16, the safe-harbor rule considers an investment to be held for investment purpose if you rent the property at a fair rental for 14 days or more in each of the two 12-month periods following the exchange.
  5. Holding a property for a reasonable amount of time is one way you can demonstrate that you have an investment intent for the property. While there is no specified amount of time you must hold, it is common practice to hold the property for at least two years before starting a 1031 exchange.
  6. If you’ve fulfilled all the steps listed above, then your property is most likely qualified for a tax-deferred exchange. But before you start a 1031 exchange, it’s advisable to consult with an experienced qualified intermediary to confirm that you meet all the property conversion requirements. This is because failure to satisfy any of these criteria may disqualify your exchange from the tax benefits of a 1031 exchange.

Pros and Cons of Using a Primary Residence for a 1031 Exchange

Pros and Cons of Using a Primary Residence for a 1031 Exchange

Using a primary residence for a 1031 exchange by converting it into a qualified investment property can offer some financial advantages. However, it also comes with some complexities and potential downsides. Here are the pros and cons of using a primary residence for a 1031 exchange:

Advantages of Using a Primary Residence for a 1031 Exchange

The most significant benefit of converting a primary residence into a qualified investment property for a 1031 exchange is the deferral of capital gains taxes that you would’ve paid when you sold your old property. As long as you adhere to the requirements, you can continue to defer capital gains taxes indefinitely through multiple successive exchanges. In the event of the investor’s death, their heirs may inherit the properties at a stepped-up basis, making it possible to eliminate the deferred taxes entirely.

Secondly, deferring capital gains tax frees up more investment capital for the investor. With that, you can possibly acquire more expensive or higher-quality properties than you could have if you had paid taxes on the capital gain. This can boost potential returns on investment through both increased rental income and capital appreciation.

Remember that the replacement property must be of equal or greater value than the relinquished property. Hence, converting a primary residence into an eligible real property provides an opportunity to exchange the property for replacement properties with higher fair market value without immediate tax burdens.

For investors managing several smaller properties, a 1031 exchange can be an effective strategy to consolidate them into one larger property. This can reduce management complexity and potentially increase operational efficiency. Moreover, a 1031 exchange can help you secure properties in other locations to satisfy business needs. For instance, you can exchange a warehouse in your city for another warehouse in another city where your business is moving into.

In addition, by converting a primary residence into a rental property, you turn a non-income-generating asset into one that produces rental income. That way, you increase your investment portfolio’s value and income stream. Additionally, you can diversify your real estate portfolio by acquiring various types of properties in different locations through a 1031 exchange.

Disadvantages of Using a Primary Residence for a 1031 Exchange

The processes, rules, and requirements involved in turning a primary residence into a 1031 exchange property can be complex sometimes, especially for inexperienced investors. If you do not carry out a step correctly, you could face significant tax liabilities.

Furthermore, if you convert your primary residence into a rental property, you may lose the ability to use the Section 121 exclusion ($250,000/$500,000 in capital gains exclusion) if you don’t sell the property while it still qualifies as a primary residence.

Moreover, to qualify for a 1031 exchange, the property must be held as an investment for a significant period, typically at least one to two years. This means that you can’t quickly change your mind and reconvert it to a primary residence without jeopardizing the 1031 exchange.

Top 5 Tips For Converting a Primary Residence to a Qualified Property For a 1031 Exchange

Top 5 Tips For Converting a Primary Residence to a Qualified Property For a 1031 Exchange

It takes a proper understanding of the requirements and some careful planning to successfully convert a primary residence into a 1031 exchange property. We understand that the processes can be challenging sometimes; that’s why we’ve put together these 5 pro tips to guide you.

  1. Evaluate your long-term investment goals and how converting your primary residence into a rental property fits into these plans. Crosscheck that the benefits, particularly tax deferral from a 1031 exchange, align with your investment strategy and financial objectives.
  2. Make sure you establish a clear investment intent. Beyond just renting the property, you should also adjust your insurance to a landlord or investment property policy and modify any applicable homeowners’ association (HOA) agreements.
  3. Rent the property at a fair market rate. Renting the property to a family member at a significantly reduced rate, for example, might not qualify as a bona fide rental for IRS purposes.
  4. Your records are very important to establishing the property’s new status as a business property. Be sure to document every step, and preserve important documents such as lease agreements and rent receipts.
  5. Consult with a Qualified Intermediary. Property conversion involves a lot of technicalities that you likely need help navigating. Apart from the processes, you need to understand how and where to report tax on a 1031 exchange to be sure there are no tax mistakes that could attract penalties. The exchange rules also prohibit you from holding constructive receipt of the sales proceeds of the relinquished property in a traditional exchange, or the title of the new property in a reverse exchange. Considering all these, the experienced qualified intermediary fees are worth having someone facilitating the exchange and helping you stay compliant throughout the process.

Need a Qualified Intermediary?

You can successfully convert a personal residence into an eligible 1031 exchange property if you understand the requirements and follow the rules. It’s important to establish investment intent by renting the property and adjusting your insurance and agreements. Be sure to keep the documents safe and secure; you might need them for reference purposes. File and report your taxes accordingly as failure to do so may disqualify your exchange from tax deferral and may also attract legal penalties.

It’s best to consult with a Qualified Intermediary to guide you through and make sure you fulfill all legal requirements to avoid costly mistakes that may result in severe consequences. Universal Pacific 1031 Exchange is committed to making the exchange process smooth, fast, and error-free. You can visit our 1031 exchange offices in Los Angeles or schedule a free consultation with us today to discuss your options and start an exchange.

 

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.