How To Convert 1031 Exchange Property Into Principle Residence

For a long time real estate investors have seen the advantage of using a 1031 exchange to buy a replacement property and then convert the replacement property into their principal residence. By doing this, the taxpayer first takes advantage of the tax deferral of a 1031 exchange and then takes advantage of the tax exclusion under I.R.C. section 121.

Just to remind you of the rules of I.R.C. section 121: individual homeowners can exclude from income capital gains from the sale of their principal residence provided: 1) They have owned AND lived in the property for 2 of the last 5 years, and 2) They have not used the exclusion in the last two years, and 3) The gain is not greater than $250,000 {$500,000 for a married couple}, and 4) Your principal residence is generally defined as the place where you have spent the majority of your night and you may only have one principal residence at a time.

Naturally the I.R.S. has viewed combining the use of a 1031 exchange with exclusion of income under 121 as abusive and a drain on the treasury. At the same time, everyone recognizes that a prohibition on change of use of property would be unduly prohibitive.

In Rev. Proc. 2008-16 the I.R.S. has dealt with this issue by creating a “safe harbor” for taxpayers. The rules for the safe harbor of combining 1031 exchange with tax exclusion under I.R.C. section 121 are as follows: 1) A property qualifies as a replacement property under 1031 if it is used as a rental for two years prior to converting the property to personal use, and 2) It must be rented for at fair rent for least 14 days a year, and 3) The taxpayer’s own use does not exceed 14 days per year or 10% of the days rented at fair rent, whichever is less, and 4) The property can be rented to a related party as long as fair market rent is paid to the taxpayer. If the “safe harbor” rules are met then the I.R.S. will not challenge the tax deferral of the 1031 exchange.

THEREFORE a taxpayer can buy a replacement property in a 1031 exchange, rent it out for two years, convert the use to principal residence for an additional two years, and take the gain exclusion under I.R.C. section 121, BUT, limited as follows: For any 1031 exchange that takes place after January 1, 2009 gain will be apportioned between the time when the replacement property is held as rental and the time it is held for principle residence. For example, a 1031 exchange a property is bought in June 2009 and is used as a rental for 2 years. Then it is converted to principal residence and used as principal residence for three years until June 2014 at which time it is sold. In this example 60% of the gain (3 years) is excluded under section 121 and 40% of the gain (2 years) is taxed. CAUTION: Recaptured depreciation must also be taken upon sale of any property in which the gain is otherwise excluded under section 121. Most of the rules set forth in the article are contained in I.R.C. section 121.

Keep in mind that situations outside the “safe harbor” do not necessarily void a 1031 exchange.  Sometimes an unforeseen change of circumstance occurs and that change of circumstances justifies an earlier change of use of the property from rental to personal use. The burden of proof is always on the taxpayer.