1031 exchanges are part of a strong, holistic investment strategy that diversifies your portfolio with different types of investment properties and/or allows you to choose properties that are easier to manage, like triple net lease properties.
A standard 1031 exchange allows investors to defer capital gains taxes on the sale of an investment property, which provides tremendous tax savings for investors. It also makes it easier to upgrade to a larger or better-performing property using leverage.
However, when structured intentionally, a 1031 exchange can be done on personal properties, including one method savvy investors can use to legally defer federal capital gains taxes on a personal residence.
How to Perform a 1031 Exchange on a Personal Residence
Typically the IRS excludes a 1031 exchange on a primary residence since personal residences are not commercial properties. However, Section 121 of the Internal Revenue Code (IRC) provides some situations in which a 1031 exchange on a primary residence could be conducted.
You cannot be living in a 1031 exchange property at the time of the exchange.
Section 121 of the IRC states that a personal residence can be exempt from capital gains tax through a 1031 exchange if an investor has owned the property for at least five years and lived in it for two out of those five years. To be eligible for the exchange, you must be able to show the IRS that you rented out the property at market rate and prove that you lived elsewhere while using the property for business purposes.
Example of How to Perform a 1031 on a Primary Residence
As of December 2023 , you can take a $250k/$500k gain as a tax-free gain on the sale of a former primary residence (be sure to consult your tax specialist or CPA for details pertaining to your situation). Any gain above and beyond that number would be taxable, so performing a 1031 exchange would defer those capital gains taxes.
This is a fairly technical concept, so here is an example:
I own five units in an apartment complex and lived in one unit for two of the five years.
I paid $1M for the property ($200k for each unit) and eventually sold the complex after five years for $2M ($400k for each unit).
I do not need to pay taxes on the unit I used as a primary residence, as it is below the $500k threshold ($400k), but I could perform a 1031 exchange for the remaining $1.6M, as long as I purchase other investment properties with the profits.
If you own more than one residence, some investors choose to live in one residence for a period of time, and then move to the second one, renting out the first one. Because the IRS lets you have only one primary residence at a time, you are able to do this as long as you can prove that your primary residence has changed. You can then convert the first residence to a rental property.
How to Convert a Rental Property or Vacation Home to a Primary Residence Using A 1031 Exchange
Another option to manage a 1031 exchange on a personal residence is to do the reverse of the previous example.
The IRS also allows you to convert a property that was previously used as a rental into a primary residence and carry out a 1031 exchange. To make this work, you must show that you have not lived in the property for more than fourteen days out of every 12-month period and that the property has been rented out for at least 24 months.
This stipulation is called “qualified use,” and, for many investors, often applies to a secondary vacation home that the owners rent out while they live in their primary residence for most of the year. “Qualified use” can also apply to properties used as Airbnb or Vrbo rentals.
To take advantage of the qualified use exemption, you will need to prove to the IRS that you rented out your property at the market rate. This could mean advertising the property and retaining proof of what the going prices were for similar properties. Also, you are not allowed to make any custom changes to the rental that are for your use during this time period.
1031 Exchange Timelines
Before commencing the 1031 process, it is advisable to already know your replacement properties and have chosen your qualified intermediary so that you don’t end up in a time crunch. The IRS only gives you 45 days from the minute you close on the original property sale to either complete the purchase of a new property or legally identify the new property you intend to purchase as part of your 1031 exchange.
You must complete your 1031 exchange within 180 days of selling your old property by purchasing one or more of the eligible properties on your list. If you choose more than three properties, they cannot exceed 200% of the value of your old property. You cannot buy property as part of the exchange that is not on the 45-day list.
How Long to Identify a 1031 Exchange Property
You have 45 days after you sell the old property to identify or buy the new property or properties you intend to purchase.
You must own your new property within 180 days of the sale of the old property or by the due date for your tax return for the year in which the transfer of the old property takes place, whichever arrives first.
The exchange must be completed in 180 total days, not 45 days plus 180 days.
Performing a 1031 Exchange on Primary Residence is Possible.
Performing 1031 exchange on a primary residence that you converted to a rental or vice-versa is a great investment strategy, but it’s also a complicated endeavor. This is why it’s highly recommended you assemble your team of professional advisors from Westwood Net Lease Advisors.
Westwood Net Lease Advisors specializes in 1031 exchanges and can help you with the entire process from planning to closing and thereafter. Our clients have had great success trading high-maintenance and costly rentals for triple net lease properties while deferring 100% of the federal capital gains taxes. Our buyer representation is free. Be sure to contact us today for a no-obligation conversation: 314-997-5227.
Please note that this article is not legal tax advice. It is purely informational about the different tax options. Consult your CPA or go to the IRS’s website for more.
A principal residence usually does not qualify for 1031 treatment because you live in that home and do not hold it for investment purposes. However, if you rented it out for a reasonable time period and refrained from living there, then it becomes an investment property
investment property
Investment properties are those that are not used as a primary residence. They generate some form of income—dividends, interest, rents, or even royalties—that fall outside the scope of the property owner's regular line of business.
What Property Types Qualify for a California 1031 Exchange? 1031 exchanges can only be used when selling business or investment properties, so your primary residence isn't eligible (fortunately, the tax code provides a separate exemption for selling your home).
While most financial analysts will answer no to this question, once you equip yourself with the proper knowledge, you'll discover that there's a way to go about it. Technically, you can't use a 1031 exchange to pay off a property you already own.
A 1031 exchange can be disqualified if the property being exchanged is not used for business or investment purposes, if the exchange is not completed within the specified timelines, or if the exchange does not meet IRS regulations.
Converting a primary residence to a rental property takes time, but if done right, can prove to drastically improve your passive income in just a few months. Tenant demand for single-family rental properties in many markets is reaching all time highs and rents are still growing in some markets.
As long as you lived in the property as your primary residence for 24 months within the five years before the home's sale, you can qualify for the capital gains tax exemption. And if you're married and filing jointly, only one spouse needs to meet this requirement.
Section 1031(f) provides that if a Taxpayer exchanges with a related party then the party who acquired the property in the exchange must hold it for 2 years or the exchange will be disallowed.
Yes, it is possible to move into a 1031 exchange property as your primary residence. If you acquire a replacement property but change your mind about how you want to use it, the Internal Revenue Service (IRS) will tax your capital gains for selling the other property.
If the property you are relinquishing has a mortgage, you will have to pay it off when you sell. However, to receive the full tax deferral of a 1031 exchange, you'll need to take out a new mortgage of equal or greater value when purchasing your replacement property.
Good news for house flippers: They qualify for a 1031 exchange, with a few conditions. Franco says the property must be owned for two years for it to qualify, so if owners flip too fast it won't work.
The property must be a business or investment property, which means that it can't be personal property. Your home won't qualify for a 1031 exchange. However, a single-family rental property that you own could be exchanged for commercial rental property.
One of the downsides of 1031 exchanges is that the tax deferral will eventually end and you'll be hit with a big bill. However, there is a way around this.
The two most common situations we encounter that are ineligible for exchange are the sale of a primary residence and “flippers.” Both are excluded for the same reason: In order to be eligible for a 1031 exchange, the relinquished property must have been held for productivity in a trade or business or for investment.
First, you can transition your primary residence into an investment property and then sell it, allowing you to use it in a 1031 exchange. The best way to complete this transition is to live elsewhere and use the former residence as a rental for two years.
People who own investment property can defer their capital gains by rolling the sale of one property into another. This like-kind exchange does not apply to personal residences, however.
In addition to the down payment, there are a number of ongoing costs specific to homeownership, too, including mortgage payments and interest, property taxes, utilities, homeowners association fees and ongoing repairs. All of these expenses may make homeownership out of the question.
Yes, it is possible to move into a 1031 exchange property as your primary residence. If you acquire a replacement property but change your mind about how you want to use it, the Internal Revenue Service (IRS) will tax your capital gains for selling the other property.
Yes, a second home can qualify for a 1031 exchange, but it must adhere to specific conditions. The property should primarily be used as a business or investment asset and not for personal enjoyment. The IRS applies strict rules regarding personal usage of the property to maintain its eligibility for a 1031 exchange.
While engaging in a 1031 exchange with a family member is possible, it should be approached with caution. If you decide to move forward, do so with the understanding that the IRS will likely examine the transaction to confirm that all the rules and guidelines have been followed.
Introduction: My name is Patricia Veum II, I am a vast, combative, smiling, famous, inexpensive, zealous, sparkling person who loves writing and wants to share my knowledge and understanding with you.
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