The 1031 Adviser: Converting 1031 Replacement Property into a Principal Residence

1031 Exchange Residential Real Estate Law

It’s not uncommon for an investor to convert a property held for business, trade or investment into one’s principal residence. Change in investment potential of the property, or a desire to get out of the landlord business, might make the investor decide to change the use into one held as a primary residence. And prudent investors may have utilized IRC section 1031 to defer gains from prior sales of relinquished property, thus accumulating gains in the process which have been rolled into the property that is now being “converted.” What happens to those gains once the property is converted to a principal residence?
An analysis should begin with how long the replacement property was held for business, trade or investment. Section 1031 of the IRC allows a gain to be deferred when the taxpayer is selling property held for business, trade or investment, and properly exchanges it held for another property held for business, trade or investment (the “replacement property”). If the taxpayer complies with the exchange rules, then the gain from the relinquished property can be “rolled into” the replacement property. Whether the replacement property is, indeed, one held for business, trade or investment likely depends on both the taxpayer’s intent at the time of the exchange (did the taxpayer “intend” to acquire the replacement property for business, trade or investment) and the actual use of the replacement property. If the taxpayer converts the replacement property into his primary residence one day after acquisition, it will be difficult to show that at the time of the exchange the intent was to acquire for investment purposes. In the same way, a quick sale of the replacement property will suggest speculative purpose (not permitted), and the exchange may be tainted by such a quick conversion.
But if the taxpayer holds the replacement property for at least a year, and then changed circumstances require a modification in use to that of principal residence, then it’s unlikely that the exchange would be disallowed. Moreover, there is no obligation at the time of the changed use (when the taxpayer converts the property from investment to primary residence) to recognize the deferred gain.
What about when that property is sold? Then IRC section 121 would control. A taxpayer selling a principal residence is exempt from the capital gains tax on the first $250,000 of the gain (or $500,000 for married couples filing jointly) if at the time of the sale it has been the taxpayers principal residence for a cumulative 2 of the last 5 years. Any gains in excess of the $250/$500K would be subject to long-term capital gains tax at the time of the sale, including any gain that had been deferred into the residence through properly executed 1031 exchanges.
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