A 1031 exchange is an investing tool that allows you to swap an investment property, such as a rental house, for another and defer the capital gains tax you would have to pay at closing. Investors commonly use this method to upgrade to better or larger properties without having to pay tax on the proceeds. However, you may want to know if you can use your investment property as a primary residence.
For instance, you may have completed a 1031 exchange on a rental property but decide you want to use it as your permanent family home after the sale. This article reviews the requirements and exceptions for converting an exchange property into your principal residence and covers how you can make the real estate exchange process more efficient.
Is It Possible to Move Into a 1031 Exchange Property?
Yes, it is possible to move into a 1031 exchange property. 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.
Your principal residence does not qualify as an investment property, and you cannot use your replacement properties as personal residences without jeopardizing your 1031 exchange. However, you can avoid this situation by following a few rules to still reap the benefits of the 1031 exchange before making it your principal residence.
The most important thing to remember is the IRS wants to ensure you had intentions to secure the 1031 exchange property for investment or business purposes only. If it looks like you bought the new property to make it into your dream home, you must pay taxes on the profit you made selling your last property.
If you want to turn your investment property into a principal residence, you cannot immediately move into the 1031 exchange property after the closing without sustaining tax liability. To avoid paying capital gains taxes, you must retain the property as a rental unit for at least two years before you can convert it into a vacation house or primary residence.
The IRS has established other specific terms for a 1031 exchange in this case, including:
- You must rent the replacement property for at least 14 days during one of the two years of ownership. You can rent to anyone, but it must be at a fair rental market price and documented in writing.
- Your personal use of the property, including occupancy, must not exceed either 14 days or 10% of the total number of days you rented out the property within 12 months.
- This exchange only applies to single-owner properties.
- Once the 24 months conclude, you can move into the property and declare it a primary residence.
The IRS established these requirements for owners to clearly show their intent to hold the replacement property for investment purposes before changing the 1031 into a principal residential property. If you don’t follow these rules, you risk an exchange challenge from the IRS, and your capital gains may be taxed.
What the Tax Code Says
Before making your investment property your primary residence, you should review the restrictions and requirements for a 1031 exchange and what you need to do to qualify.
Generally, a 1031 exchange is only valid if you use the profit from selling your old rental property to invest in another, like-kind property. Properties are like-kind when they’re of the same nature, character, or type of real estate. For instance, a single-family home could be like-kind to an industrial building if they will both be used for rental or business purposes. You may also exchange a commercial building for raw land, as long as both properties are solely used for commercial or rental purposes.
The tax code also specifies three main types of 1031 exchanges, which can include a rental property you may want to convert into your personal residence. These three structures all require an exchange of property, including:
- Simultaneous exchange: In this exchange, you swap your property for another without a waiting period. This allows you to close on the former property and your replacement property simultaneously.
- Deferred exchange: This 1031 exchange is the most common and allows you to dispose of your old property and acquire a like-kind replacement. However, you must identify your replacement property within 45 days of closing on the old property and acquire it within 180 days.
- Reverse exchange: A reverse exchange is a bit more complex because it involves acquiring a new property before selling or disposing of your old one. In this 1031 exchange, you have 180 days to dispose of your relinquished property after acquiring the replacement to close the exchange.
There are some restrictions for deferred and reverse exchanges. For example, taking control of cash or proceeds before closing on a replacement property can disqualify the exchange and make all gains taxable. Likewise, only the proceeds not spent on acquiring a like-kind property are taxable.
To avoid receipt of proceeds or cash, use a qualified intermediary (QI) who can act as an exchange facilitator. A QI will hold your funds and help you conduct the process until the 1031 exchange is complete.
Here are some key qualifications for like-kind properties in these exchanges:
- The relinquished and replacement property must be intended for investment, trade, or business.
- Properties intended or primarily used for personal use or as a vacation home do not qualify as a like-kind exchange.
- The quality or grade of the property does not matter, only that the properties are similar in real estate use.
- Property within the U.S. is not like-kind to property outside the country.
- Real property is not like-kind to personal property.
- Stocks, bonds, certificates of trust, or partnership interests do not qualify as like-kind property and are excluded from 1031 exchange treatment.
Tips to Follow When Converting 1031 Exchange Property Into a Principal Residence
You may want to turn your rental property into your primary residence to downsize or relocate where the cost of living is lower. If you acquired this rental property through a 1031 exchange, you could still turn it into your personal residence by following specific guidelines.
To meet the qualified purpose requirements of a 1031 exchange, you must use the property you relinquish and the one you acquire for productive business or investment. Another critical component is your intention when you acquired the replacement property. Suppose you honestly acquired it for business purposes, such as renting, but have a change in circumstances that leads you to use the property for personal use. In that case, you may be able to convert your 1031 to your principal residence without paying capital gains taxes if you own it for the required period.
You may need to prove that you intended to use the property as an investment and did not move into it immediately for your own use, such as making it a vacation home upon closing. The IRS calls this the safe harbor test, which determines how long a rental property acquired through a 1031 exchange must be held before you can turn it into your principal residence.
Here are some best practices and things to avoid to provide evidence of intent through the safe harbor test:
- Do not create a contingency in the replacement property sale contract for the sale of your old property.
- Do not begin construction on the property for personal use immediately after purchase.
- Document how you determined the rent price for your property.
- Use and save copies of listings and advertisements of the rental property at a fair market value.
- Do not move into the house right after closing, even temporarily.
- Avoid having plans drawn up to turn the acquired property into a vacation home or principal residence around the time of the exchange.
- Do not prematurely disclose any plans to move into the property.
- Document any change of circumstance that causes you to need the property as a primary residence and include any relevant paperwork or legal files.
- Save the contact information of potential tenants looking to rent on your property or anyone else who was interested in living there.
- Ensure the replacement property allows the home, condo, or apartment to be rented.
These are some fundamental factors to consider before going through a 1031 exchange. They can save your exchange if you need to provide documentation or call on witnesses to show you intended to use the property for business when you initially acquired it. Otherwise, the exchange may be invalidated.
However, if you can’t meet the criteria above to prove your intent, the next best thing to do is to use the property for investment or business purposes for an extended period, if you can. For instance, if you can rent the property for a minimum of two years, you’ll likely be able to show the investment intent.
The IRS will also look to ensure you are listing your real property for rent at a fair value. If you list your monthly rent way above the market average, the IRS may assume you are trying to avoid renting it out.
Is It Worth It to Convert My 1031 Exchange Property?
While converting your 1031 property into your principal residence is a personal choice, it might make sense in some situations. In certain life-altering circumstances, you can show the IRS that it’s suitable or necessary to move into your rental property and make it your principal residence, including:
- Unexpectedly losing your job
- Becoming disabled
- Getting divorced
- Severe injury or health condition
- Getting married
- Taking in an elderly parent or loved one
If your situation fits one of these life-altering events, it’s critical to document these reasons and keep any paperwork that the IRS may need to confirm your justifiable exception. In these cases, you will still need to prove that you initially acquired the property for rental or investment purposes.
4 Common 1031 Property Exchange Mistakes
Even the most minor issue can cause your 1031 exchange to fall through and ruin your real estate investment plans. Here are five common mistakes to avoid with a 1031 exchange.
1. Waiting Too Long to Set up a 1031 Exchange
It’s best to execute 1031 exchange documents as early as you can. Closing the sale before you execute the documents will invalidate the exchange and you’ll have to pay capital gains taxes. As an investor, you may wish to wait until a contract is ready for the relinquished property before determining what you will do with the proceeds from the sale, but this often leaves too little time to prepare the 1031 exchange and find a replacement property. The earlier you consider your options and discuss an exchange with your advisors, the easier it will be to secure the 1031 exchange benefits.
2. Believing 1031 Exchanges Eliminate Tax
A common myth is a 1031 exchange allows you to avoid taxes indefinitely. However, a 1031 exchange only defers taxes — it does not eliminate them. If the exchange becomes invalid through failure to prove intent of use or if the exchanger does not find a replacement property within the required time limit, the capital gains in the exchange will become ordinary income, which will be taxed at a much higher rate. If a 1031 exchange is successful, the tax is deferred until the investor decides to sell the property for cash or passes away. Then there will be a step up in basis for the heirs.
3. Lacking Proper Planning and Understanding
You only get 45 days to identify a replacement property. You may identify two or three properties as long as you close on one of them. Remember, your replacement property must be like-kind, and you must take on an equal or a greater amount of debt. If you haven’t identified a property within that time, your exchange can fall through, and you’ll lose your opportunity. These 45 days generally cannot be extended if you run out of time.
However, you don’t need to complete the negotiations and secure financing for the property within 45 days — you only have to identify it, which can be easier with a proper identification strategy. You have 180 days total to complete the exchange.
4. Not Utilizing a Real Estate Investment Platform
For many investors, finding an appropriate property within 45 days can be challenging. A real estate investment platform, such as 1031 Crowdfunding, lets you view a large online marketplace for vetted real estate properties that meet your needs. This platform also helps mitigate closing risks by helping you identify your replacement property promptly.
1031 Crowdfunding enables you to source more deals for real estate exchange and find properties in various asset classes to diversify your investment portfolio. We offer a unique approach to real estate exchanges through a marketplace of Delaware Statutory Trusts (DSTs). This type of offering allows investors to own a portion of real estate with the potential to invest in more properties than before. DSTs qualify for 1031 exchanges and provide many benefits for investors, such as offloading the responsibility of caring for the rental properties on your own. As with any real estate investment, DSTs also come with potential risks, such as incurring more fees and expenses and various regulatory constraints from the IRS.
Learn More About Converting a 1031 Into a Principal Residence
At 1031 Crowdfunding, you gain access to our large-scale marketplace of vetted properties for a 1031 exchange. These properties allow you to defer capital gains taxes and increase your cash flow. Our platform inventory makes it easy to find an appropriate property and complete your exchange within the required time. Most of our clients complete 1031 exchanges within a week.
When you register as a member, you will also get support from our real estate experts, who can guide you through the process and help you make informed decisions based on your investment goals. An account on our platform provides you with the necessary documents and details to complete all your paperwork online correctly and efficiently.
To streamline your future 1031 exchanges, create an investor account today and see how we can help you find your next investment property.
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