When it comes to investing, 1031 exchanges have become an important tax strategy. It allows real estate investors to defer capital gains taxes on the sale of one investment property by reinvesting the proceeds into another property. Based on this, many people wonder if this strategy can be used for their primary residence. The short answer is no.
The good news, however, is that there are some exceptions that may apply in certain situations. Understanding the rules and requirements of 1031 exchanges for primary residences can help you – the homeowner – make salient decisions about your real estate investments and tax planning strategies. So let’s get started!
What Qualifies as a 1031 Exchange Primary Residence?
A 1031 exchange is a tax-deferred exchange of real estate properties that allows investors to defer (delay) paying capital gains tax on the sale of a property by reinvesting the proceeds into another like-kind property.
Pertaining to this, under the IRS regulations, a former primary residence or principal residence is not eligible for a 1031 exchange. To break it down:
A primary residence is the home where a taxpayer lives for most of the year.
According to the IRS, a primary residence is a property that’s occupied by the owner for at least 2 of the 5 years before the sale.
If you sell your primary residence and make a profit, you may be able to exempt up to $250,000 (if single) or $500,000 (if you're married and filing your taxes jointly) in capital gains taxes if you meet certain criteria.
Simply put, a primary residence does not qualify for a 1031 exchange. In relation to this, if you're selling your primary residence and making a profit, you may be able to exclude some or all of ordinary income from the capital gains taxes through a different tax provision. It's important to work with a qualified professional who can help you navigate the rules and requirements.
The Solution: How to Actually Do a 1031 Exchange On Your Primary Residence
Remember those “exceptions” and caveats we hinted at in the beginning of this post? Here they are:
Conversion to Rental Property
If you convert your principal residence into a rental property, and meet all the 1031 exchange requirements, you can use a 1031 exchange to a new property and defer the tax liability on the sale of that property.
Here are the requirements you need to comply with in order to qualify for a 1031 exchange:
Like-Kind Property: The property being sold and the property being purchased must be considered "like-kind" in the eyes of the IRS. This means they must be of the same character or nature, even if they are different in grade or quality.
Qualified Intermediary: The use of a qualified intermediary (QI) is required to facilitate the 1031 exchange process. The QI acts as a 3rd party intermediary to hold the proceeds from the sale of the relinquished property and to acquire the replacement property.
Investment or Business Property: Both the property being sold and the property being purchased must be held for investment or used in a trade or business.
Identification and Acquisition Periods: You must identify the replacement property within 45 days of the sale of the relinquished property, and must acquire the replacement property within 180 days of the sale.
Equal or Greater Value: The replacement property’s value must be equal to or greater than the value of the relinquished property. Any cash received in the exchange is considered “taxable boot” and will be subject to capital gains taxes.
Vacation Homes
A vacation home that was rented out for at least 14 days in each of the 2 years preceding the sale can potentially qualify for a 1031 exchange.
A vacation home is considered a type of investment property if it is rented out for at least part of the year. If this property was rented out at a fair market value for at least 14 days in each of the two years prior to its sale, it may qualify for a 1031 exchange. The rental income from this replacement property must also be reported on your (i.e., the owner) tax return as rental income, not as personal use. You must also intend to hold the replacement property for investment purposes, not as a personal residence.
For capital gain taxes for example, if you have a vacation home that was rented out for at least 14 days in each of the last 2 years, and you sell it for $500,000, you can use a 1031 exchange to defer capital gains tax. You can then reinvest the full $500,000 (minus any expenses) into a replacement investment property, such as a rental property or commercial property.
Partial Exchanges
It’s possible to use a 1031 exchange on only a portion of a property that is used both as a primary residence and a rental property, as long as certain requirements are met. If a property is used both as a primary residence and a rental property, the IRS requires that the taxpayer allocates the property's use between personal use and rental use, and only the rental portion of the property can be exchanged.
In addition to this requirement, the following conditions must be met in order to use a 1031 exchange on real property or a portion of a property that is used as both a primary residence and a rental property:
The rental portion of the property must be held for investment purposes, meaning it must be rented out for a fair rental price and not used as a vacation home or personal residence.
You (i.e., the taxpayer) must have owned the property for at least 24 months prior to the exchange.
You must have rented out the property for at least 14 days per year or 10% of the number of days the property was used as a rental, whichever is greater.
You must follow the other general requirements for 1031 exchanges, such as using a qualified intermediary, identifying replacement property within 45 days, and completing the exchange within 180 days.
Considering the numerous complex rules surrounding the 1031 exchanges for personal residences, and real estate assets it is highly recommended to consult a tax professional or financial advisor for guidance.
A Note on IRC Section 121 and 1031 Exchange Property
Some people believe that Section 121 of the Internal Revenue Code (IRC) allows the tax code for a 1031 exchange on primary residences. This is NOT true at all so beware. It’s not a tax deferral strategy like a 1031 exchange.
What Section 121 actually does is that it provides for a capital gains exclusion of up to $250,000 ($500,000 for married couples who file jointly) for individuals who sell their primary residence and have lived in it for at least 2 out of the past 5 years.
This means that if the capital gains on the sale of the primary residence fall below the exclusion limit, no capital gains taxes would be owed, and a 1031 exchange would not be necessary. Taking this into account, if the capital gains exceed the exclusion limit, a 1031 exchange cannot be used to defer those to pay capital gains taxes.
For example, say you and your spouse sell your primary residence that you both have lived in for at least 2 out of the past 5 years and realize a capital gain of $400,000. You’d be able to exclude $500,000 of that gain under Section 121, leaving you with a taxable gain of $0. Since your taxable gain doesn’t exceed the exclusion limit, you wouldn’t need to utilize a 1031 exchange to another capital asset to defer any taxes.
How to Determine if a Property Qualifies for a 1031 Exchange?
If you are wondering whether your property is eligible for a 1031 deal, it has to meet the following requirements:
The property must be held for investment, business, or productive use in a trade or business
It must be exchanged for another property that is also held for investment, business, or productive use in a trade or business
Both the relinquished property (the property being sold) and the replacement property (the property being purchased) must be like-kind
The exchange must be completed within the 180-day exchange period
As we explained earlier, properties held primarily for personal use don’t qualify for 1031 exchanges (the exceptions to this rule are also explained above). A property doesn’t have to be a rental either to qualify for a 1031 exchange; it just must be held for business or investment purposes. This means that properties such as vacation homes, commercial or investment properties,, and raw land can also potentially qualify for a 1031 exchange, as long as they meet the requirements set forth by the IRS.
To clarify, if you own one property the following types of properties, you can execute a 1031 exchange:
Rental properties
Commercial properties
Raw land
Vacation homes
Industrial properties
Agricultural properties
Oil and gas interests
In addition, certain types of like-kind personal properties used in a trade or business can also potentially qualify for a 1031 exchange. These may include:
Heavy equipment
Vehicles used for business purposes
Office furniture and equipment
Manufacturing machinery
Livestock
Artwork and collectibles used for business purposes
The rules and requirements for personal property exchanges can be more complex than those for real estate exchanges. The tax treatment of personal property exchanges also tends to vary depending on the specific type of property and tax liabilities involved. So, please consult with a qualified intermediary (QI) or tax advisor before trying an exchange.
Consulting with a QI is recommended to help you determine if your property meets the requirements for a 1031 exchange. They are an independent third-party that can also help you in setting up the property exchange, and completing the necessary paperwork.
Consider 1031 Exchanges to Meet Your Investment Objectives
Are you looking to navigate a 1031 exchange? Pivot Professional Partners, a Miami-based 1031 Exchange advisory firm, can help you with your investment goals. Led by CEO and Founder Jon Paul Cirelli, our investment professionals can provide dedicated advice to help build and maintain your alternate investments portfolio.
We will work closely with you to understand your situation, suggest financially prudent strategies, and help you implement the right investments for your unique needs. Give us a call at (631) 275-1444 or send us a message here to learn more about how we can help you with your 1031 exchange.
IMPORTANT: We are not Qualified Intermediaries; we are financial advisors with niche in providing active and passive solutions for investors. While a 1031 is considered a tax strategy, we are not tax advisors, and you should consult your tax professional before investing.