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Can You Live in a 1031 Exchange Property?

December 26, 2023

According to the Internal Revenue Code, Section 1031, exchange of properties for personal use does not qualify for capital gains tax deferral. 1031 exchange properties must be like-kind, and both the relinquished property and the replacement property must be held for business or investment purposes.

However, you can live in a property acquired through a 1031 exchange under certain conditions. To stay complaint and maintain tax benefits, you need to understand the IRS requirements for converting a 1031 exchange property into a personal residence.

With over 32 years of experience in facilitating 1031 exchanges, our experts at Universal Pacific 1031 Exchange have the required experience to guide you through a smooth and compliant 1031 exchange property conversion. We’re always available to answer your questions and facilitate your exchange. Schedule a free consultation with us today to get started.

In this article, you’ll learn the IRS rules regulating the conversion of a 1031 exchange property into a residence, the processes involved, and pro tips for a successful conversion for real estate investors.

General IRS Rules Regarding Personal Use of 1031 Exchange Properties

General IRS Rules Regarding Personal Use of 1031 Exchange Properties

The Internal Revenue Service (IRS) has stipulated specific rules regarding the personal use of properties acquired through a 1031 exchange, which is primarily designed for investment and business properties. The rules are as follows:

Primary Purpose as Investment

The replacement property obtained through a 1031 exchange must be primarily held for investment purposes, not for personal use. This means the intent at the time of the exchange should be to use the property as an investment, rather than a residence.

Limited Personal Use

Personal use of the property is allowed but should be limited. The IRS provides a safe harbor rule, where a living unit can qualify as a property held for productive use in a trade or business or for investment if it is rented at a fair rental for 14 days or more during the year. Also, the personal use should not exceed the greater of 14 days or 10% of the number of days during the year that the property is rented at a fair rental.

Conversion to Primary Residence

If you wish to convert your 1031 exchange property into your primary residence, you must first hold it under the stipulations for investment use. Although there’s no specific minimum period for this, most tax advisors recommend at least one to two years of demonstrable investment use.

Selling a Converted Residence

If you later sell a replacement property that was acquired through a 1031 exchange and then converted to your primary residence, special rules apply. You can exclude gains of up to $250,000 for single filers and $500,000 for married filing jointly on the sale of a primary residence, but with limitations, especially if the sale occurs within 5 years of the exchange.

Record Keeping and Documentation

It’s crucial to keep accurate records and documentation showing the property’s use as an investment, including rental income, and efforts to rent the property.

Reporting Requirements

You must report any recognized gain due to the receipt of money or unlike property in a 1031 exchange using Form 8824, “Like-Kind Exchanges,” even though no gain or loss is recognized in most cases. You can read our blog to learn how to file tax return on 1031 exchange.

Consultation with Professionals

Given the complexities and potential for significant tax consequences, it’s advisable to consult with tax professionals or legal advisors who specialize in real estate and tax law to understand these rules fully and how they apply to your specific situation.

How to Convert a 1031 Exchange Property into a Primary Residence

How to Convert a 1031 Exchange Property into a Primary Residence

To successfully convert a 1031 exchange property to a primary residence, you need to understand the right steps to take to avoid capital gains taxes liability. Here’s a summary of the steps you need to take.

1. Understanding Tax Implications

Before making any changes, you need to understand the tax implications. Capital gains taxes can be a significant factor when you sell a property that has appreciated in value. If you live in your property as a primary residence for a certain period (usually 2 out of the last 5 years in the U.S.), you may qualify for a capital gains tax exclusion.

2. Change of Use and Mortgage

If your real property has a mortgage, you may need to inform your lender about the change in use. Some mortgage terms are specific to investment properties or rental properties and might change if the property becomes a primary residence.

3. Updating Your Insurance

The insurance for a primary residence differs from that of an investment property as it usually offers more extensive coverage. So, you may need to contact your insurance provider to update your policy.

4. Legal and Zoning Compliance

Depending on your location, make sure that the property complies with all local zoning and housing laws regarding permits or inspections for primary residences.

5. Actual Move-In and Residency

Plan your move and establish residency. You might have to change your address for legal documents, voter registration, and other official records.

6. Potential Renovations or Modifications

Plan and carry out renovations and modifications to make the rental property suitable for your needs as a primary residence and improve the fair market value. The type and complexity of the renovation may influence the time you take for this step.

7. Establishing Residency Duration

Remember that to benefit from certain tax exemptions, you typically need to live in the property as your primary residence for a specific duration.

Potential Risks of Living in a 1031 Exchange Property

Potential Risks of Living in a 1031 Exchange Property

Living in a personal property that was acquired through a 1031 exchange comes with certain potential risks, mainly revolving around tax implications and compliance with IRS rules. Some of the main risks include:

Violation of 1031 Exchange Rules

To defer capital gain taxes, both the relinquished property and the replacement property must be held for investment or business purposes. If you move into the replacement property too soon after the exchange, it could be considered as not meeting the investment intent. This may disqualify the exchange from tax deferral, which means you may have to pay capital gains taxes.

Audit Risk

The IRS may audit 1031 exchanges to verify that they comply with the rules. If an audit reveals that the replacement property was not held for investment purposes for a reasonable period before being converted to a primary residence, you might face penalties and taxes.

Capital Gains Tax Implications

If you eventually sell the property, the portion of the gain attributed to the period when the property was not used as your primary residence (the non-qualified use period) will be subject to capital gains tax. This is according to the changes made by the Housing and Economic Recovery Act of 2008.

Reduced Exclusion for Primary Residence

When you sell a primary residence, you can typically exclude up to $250,000 (or $500,000 for married couples filing jointly) of the capital gain from taxes. However, if you convert a business or investment property acquired through a 1031 exchange, to a primary residence, this exclusion is prorated based on the period of qualified use as a primary residence versus non-qualified use.

Long-Term Commitment Requirement

To mitigate some of the risks, you might need to commit to the personal property for a longer period. You need to hold it as an investment property initially and then as a primary residence for a number of years to meet both the 1031 exchange requirements and the primary residence exclusion rules.

Market Risk

Like any real estate investment, there’s a risk associated with market fluctuations. If the property’s value decreases during the investment period, it could affect your financial planning.

Financing and Insurance Challenges

Changing the use of the property from investment to personal residence can affect mortgage terms and insurance policies, potentially leading to complications or additional costs.

Legal and Regulatory Changes

Tax laws and regulations can change over time, and some changes might affect the benefits or viability of living in a 1031 exchange property. It’s recommended to stay up to date with current laws and potential legislative changes.

To navigate these risks, it’s advisable to consult with a tax professional or a real estate attorney who specializes in 1031 exchanges. They can provide guidance tailored to your specific situation, helping to ensure compliance with the complex rules governing 1031 exchanges and the use of such properties as primary residences.

Alternatives to Living in a 1031 Exchange Property

Alternatives to Living in a 1031 Exchange Property

If you’re considering alternatives to living in a property acquired through a 1031 exchange, there are several options available. Each of these alternatives has its own set of advantages and disadvantages, depending on your financial goals, lifestyle preferences, and risk tolerance.

It’s advisable to consult with financial and real estate professionals, such as an experienced qualified intermediary, to understand the implications of each option and choose the one that best aligns with your personal and financial objectives.

The alternatives include:

1. Renting Out the 1031 Exchange Property

Instead of living in the 1031 exchange property, you can continue to rent it out. Maintaining its status as an investment property makes it easy to stay fully compliant with the 1031 exchange rules. You can then either get a different rental property for personal use or purchase a new property as a separate personal residence.

2. Delayed Use as Primary Residence

Purchase the property through a 1031 exchange and use it as a rental or investment property for a specified period, usually recommended for at least one to two years. After this period, you can convert it into your primary residence, reducing the risks associated with immediate conversion.

3. Purchasing a Primary Residence Separately

Instead of converting the 1031 exchange property, you could purchase a primary residence independently. This keeps your investment property and personal property distinct, avoiding the complexities and tax implications of mixing the two.

4. Owner-Occupied Multi-Family Property

If you still wish to leverage real estate investment while having a place to live, consider purchasing a multi-family property such as a duplex or a small apartment building. You can live in one unit and rent out the others. That way, you can earn rental income while allowing you to reside on the property, though it’s important to ensure compliance with all applicable tax laws and regulations.

5. Real Estate Investment Trusts (REITs)

If you’re interested in real estate investment but want to avoid the complexities of directly managing properties, investing in REITs could be an alternative. With REITs, you can invest in a diversified portfolio of real estate assets, which can include both residential and commercial properties.

6. Diversifying into Other Investment Types

Instead of reinvesting in another property, you might consider diversifying your portfolio into other types of investments such as stocks, bonds, or mutual funds. This can spread out your risk and help you leverage the advantages of other kinds of investments.

7. Homeownership with Traditional Mortgage

You can choose to simply purchase a primary residence using a traditional mortgage. This is a straightforward approach to homeownership without the complexities of 1031 exchanges and their associated tax implications.

8. Lease with Option to Buy

Another creative approach is to lease a rental property with an option to buy it later. This can be a way to move into a home that you might eventually want to purchase, while initially keeping the arrangement as a rental.

Tips For Converting a 1031 Exchange to a Primary Residence

Tips For Converting a 1031 Exchange to a Primary Residence

  • Understand the 1031 Exchange Process, Rules, and Requirements: To maximize the tax benefits of your exchange, you need to understand the processes, rules, and requirements for a successful 1031 exchange. Learn about the IRS timelines, potential replacement properties identification rules, such as the 200% rule, equal or greater value rule, and
  • Understand the Tax Implications: Familiarize yourself with the tax rules surrounding 1031 exchanges and the conversion of such properties into primary residences. Specifically, be aware of how the Housing and Economic Recovery Act of 2008 affects the capital gains exclusion for properties previously used as investments. You also need to understand the tax implications of different types of exchanges, such as reverse exchange, delayed exchange, etc.
  • Maintain Investment Intent Initially: Ensure that the property is initially used for investment purposes. The IRS does not specify a set period for how long you must hold the property in this manner, but tax professionals often recommend a minimum of one to two years to demonstrate clear investment intent.
  • Document the Property’s Use: Keep detailed records of the property’s use as an investment, including rental income, lease agreements, and any related expenses. This documentation can be crucial if your tax return is ever audited.
  • Plan the Timing of Your Move: After you’ve held the property for an appropriate investment period, you can then consider converting it into your primary residence. Moving in too early, before at least five years from the date of acquisition through the 1031 exchange may disqualify you from capital gains tax deferral when you sell it.
  • Understand the Prorated Capital Gains Exclusion: Once you convert the property to your primary residence, be aware that the capital gains exclusion will be prorated based on the amount of time the property was used as a residence versus as an investment.
  • Consult with a Tax Professional: Tax laws can be complex and are subject to change. It’s advisable to consult with a tax advisor or attorney who is experienced with real estate transactions and 1031 exchanges. They can provide personalized advice based on your situation.
  • Comply with Local Laws: When converting the property for personal use, ensure compliance with any local zoning laws or homeowners association rules.
  • Adjust Homeowners Insurance: When you change the use of the property from an investment to a primary residence, update your insurance policy accordingly, as coverage needs and premiums may differ.

Conclusion

Although properties for personal use do not qualify as like-kind property for tax-deferred exchanges, you can still convert your 1031 exchange property to residential property if you follow the right steps.

It’s always recommended to seek professional guidance from qualified professionals to be sure you’re on the right track. As an experienced qualified intermediary, Universal Pacific can help facilitate your exchange and guide you through the conversion process.

Call us on (866) 261-1962) to start an exchange today.

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.