Converting 1031 Exchange Property into your Personal Residence

Taxpayers are always looking for a way to avoid paying taxes. The 1031 Exchange is a wonderful way to DEFER your taxes, but it does not eliminate them. So taxpayers will then get creative. What if they move into the property that they bought through the 1031 Exchange and live in the property for a few years? That will eliminate any tax because taxpayers can sell their primary residence and get $500,000 tax free from the sale if married. Not so fast...

Under the Housing Assistance Tax Act of 2008 (“Act”), the IRS stated that a taxpayer must hold the property acquired as an investment for a minimum of the first 2 years. After that, they can occupy the property and hold it for personal use. Many taxpayers then assume that if they live in the property for 2 years, they can sell it as their primary residence and get $250,000 profit tax free if they are single, or $500,000 profit tax free if they are married.

If you dig further into the Housing Assistance Tax Act of 2008, it has other requirements. First, if a taxpayer does a 1031 Exchange into a property and then moves into the property, they must own that property for a minimum of 5 years before selling.

Suppose a taxpayer exchanged into a property and rented it out for three years, and then moved into it for two years. Let us also assume that their realized gain when they sold their relinquished property was $200,000. Most taxpayers will think that the $200,000 is tax free since it was their primary residence, but that is not the case. The exclusion under the Act states that the exclusion will be prorated as follows: three-fifths of the gain ($120,000) will not be eligible under the $250,000 exclusion since they rented the property out for three-fifths of the time, while two-fifths of the gain ($80,000) will be eligible.

Taxpayers can occupy their replacement property purchased through the 1031 Exchange if they follow certain rules. But they will not eliminate the tax liability by moving in to the property. The only way to eliminate the tax is to pass the property to your heirs upon death.

For additional information, please reach out to your tax professional for specific questions or contact the specialists here at Security 1st Exchange for assistance.