Can You Convert 1031 Exchange Properties Into Primary Residences?

By Edward E. Fernandez | April 1, 2024

1031 Exchange Property

A 1031 exchange enables investors to receive a deferral on capital gains taxes from the sale of their investment property. Through this strategy, real estate investors can “exchange” one investment property for another by reinvesting the proceeds directly into a similar property of equal or greater value and defer capital gains tax. 

A tax-deferred 1031 exchange can help investors put more capital toward new investment properties and maximize equity. However, investors may eventually wish to convert their investment property into a primary residence to sell it. Though such a strategy is permitted, you must adhere to certain requirements, such as the 1031 exchange five-year hold rule.

What Is the 1031 Exchange 5-Year Rule?

Primary residences cannot be used in a 1031 exchange. However, investors can benefit from the five-year rule as an exception if they want to sell a previously acquired investment property as a primary residence. The five-year rule, also known as the five-year holding period, was created in the income tax provisions of the American Jobs Creation Act of 2004.

This exception to the primary residence rule for 1031 exchanges recognized that a property’s character may change over time, such as an investment property becoming a primary residence or vice versa.

If a real estate investor wishes to sell an investment property as a primary residence, they may only do so and defer capital gains tax if they have held the property for at least five years. To qualify for the exchange, the individual must have owned the property for the last five years, but they do not have to live in the property for the entire five years.

They’re only required to live in the property for at least two of the previous five years. However, the two years do not need to be consecutive for the full gain exclusion. For example, if an investor lives in a home for one year, rents it out for three years, and then moves back in for one more year before selling it, the property will still be considered a primary residence.

Additionally, investors do not have to live in the property at the time of the sale to qualify for this benefit. Taxpayers may generally receive a tax exemption of the gain up to $250,000 individually or $500,000 as a married couple. This is known as a Section 121 exclusion

What Are the Exceptions to the 2 out of 5-Year Rule?

If you have not spent a combined two years in your property before selling it as a primary residence, you may qualify for another exception. The IRS provides many exceptions that may allow you to defer a portion of capital gains tax on the sale of your primary residence. To qualify for a partial exclusion, you must meet one or more of the following two in five-year rule eligibility exceptions:

  • Death of a spouse
  • Divorce or separation
  • You were a service member
  • Your sale included vacant land
  • You gave birth to twins or more children
  • You made a health- or work-related move
  • You became eligible for unemployment benefits
  • Your previous home was condemned or destroyed
  • You owned a remainder interest and sold that right
  • You acquired or sold the property through a 1031 exchange

As an additional exception, the time you spent out of the house on short-term leave or vacation will not be excluded from your two-year minimum, even if you rented out the property during that time. Your claim or exclusion will be calculated based on the above circumstances and how long you lived in the residence.

To provide a rough estimate of what you may be able to exclude from your taxable income, divide the number of months you spent living on the property by 24. Then, multiply that number by $250,000 if you’re filing individually or $500,000 if you’re married and filing jointly. This amount is what you may be able to exclude on the sale of your primary residence.

Taxpayers may claim this exclusion once every two years as long as they meet the eligibility requirements.

 

Tax Considerations

Detailed record-keeping and allowing your replacement property to have its season as an investment asset is imperative. The exchange can be disallowed if the IRS suspects that you completed the 1031 exchange, intending to move in immediately. It’s best to wait at least two years. IRS Rev. Proc. 2008-16 establishes a 24-month safe harbor. Under this regulation, the IRS will not challenge your investment intent if you hold the property for at least 24 months before converting it into your primary residence.

The IRS will not challenge your investment intent if you hold the property for at least 24 months before converting it into your primary residence.

There are some ways to maximize your tax benefits in this conversion:

  • Depreciation recapture: You can convert your replacement property into a principal residence if your 1031 exchange lets you defer recaptured depreciation tax. This applies regardless of how long you have used the property as your primary residence.
  • First defer, then exclude: Establish an objective investment intent to prove that you do not plan on moving into the replacement property immediately. Investment intent is measured on the day you acquire your replacement property. For example, you may rent out your 1031 exchange property and later gift it to your beneficiaries.

Register Today to View 1031 Exchange Properties With 1031 Crowdfunding

Investing in real estate through a 1031 exchange enables portfolio diversification and can enhance your buying power as a real estate investor. When completing a 1031 exchange, it’s important to do your due diligence to prevent paying capital gains tax. At 1031 Crowdfunding, we make it easier for our clients to complete a successful 1031 exchange through our extensive online marketplace.

Our professionals will help you view eligible 1031 properties and guide you through the transaction to ensure you meet all requirements. Register for an investor account today to view our 1031 exchange properties and access our alternative investment offerings.

Register For An Investor Account

This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.

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