Wondering whether a 1031 tax-deferred exchange would allow you to utilize your principal residence? Sadly, the IRS doesn’t have a provision for doing a 1031 exchange on a primary residence. Investors can only use 1031 exchanges to defer the capital gains taxes owed on an investment or commercial property.
However, the Internal Revenue Code (IRC) provides certain exceptions that can help homeowners benefit from a 1031 exchange on their primary residence.
When exchanging a primary residence for another home or investment property, the IRC allows for specific individuals to potentially avoid capital gains tax if they have owned the property for at least five years and lived in it for two of those five years, under Section 121 of the IRC.
Investors can exchange a primary residence under Section 121 provided the building is also put to productive use as an investment property, and they must have the intention of using the replacement property for business or investment purposes. Thus, proper documentation proving this will be essential when filing their taxes and ensuring they meet all requirements set forth by IRC §1031.
Using a Primary Residence for a 1031 Exchange
The IRS generally prohibits investors from using their primary residence in a 1031 exchange. This is because 1031 exchanges are only allowed with investment properties or buildings used for commercial purposes. Yet, with adequate preparation and an appropriate transition structure, a primary residence can be used for a 1031 exchange.
Section 121 is a primary residence exclusion for dual-use properties that can help you to offset capital gains tax on your primary house under Section 1031. An example would be if you own farmland as an investment property, but you and your family occupy the farm house as a primary residence. Similarly, if you own multifamily property and occupy one unit while renting the rest, your property may qualify as both a primary residence and an investment property.
Understanding Capital Gains Tax
Without knowledge of capital gains and capital gains tax, it is impossible to comprehend 1031 exchanges. In the words of the Internal Revenue Service, a capital gain or loss is:
“The difference between the adjusted basis and the amount you realized from the sale…of a capital asset.”
Capital gains are left over when someone makes money from the sale of an asset. Capital assets include all forms of real estate, furnishings, investments, and stocks.
Changing Primary Residence to an Investment Property or Vacation House For A 1031 Exchange
Let’s examine turning your primary residence into a rental or investment property. We will use a single-family home and a three-unit family home to illustrate the process. Although the tax code doesn’t state precisely how long you must hold the property for rental purposes, it is advisable to lease the property at fair market value for at least two years in case you decide to do a 1031 exchange on the investment property later.
Single Family Home: You can change a primary personal residence into a Section 1031-compliant property by using Section 121. Once your primary residence has been used as a rental property for the minimum holding period, it is likely to qualify for exchange under 1031.
Three-Unit Family Property: You can change a three-unit home into a rental property consisting of three apartments, where you live in one and lease the other two. You can utilize Section 121 to change one principal dwelling into a 1031 rental property. Since you live in one unit and rent two out, you can do a 1031 exchange on the two rental units.
Regulations to Observe
- You must have spent two or more of the previous five years living in the property before changing.
- You can exclude capital gains of up to $250,000 when filing a single return and $500,000 for a combined return.
- You can only conduct a 121 exchange once in two years.
Comparing Sections 121 and 1031
There are things you are not permitted to do if you are trying to enjoy the tax deferral benefits of a 1031 exchange on your principal residence. First, you cannot just declare that your primary house is a rental property and then utilize it as a part of a 1031 exchange. Also, unless you own a multi-family property, you are not permitted to declare your personal residence as a rental.
Use of Section 121
You can defer paying capital gains tax under Section 1031 and exclude money from taxes when you sell a personal property under Section 121 that has been used as an investment property and a primary residence. You must have resided in the primary residence for two years or more of the previous five years to be eligible for a Section 121.
Section 121 Functions
- Tax exemption
- The use of Section 121 is limited to once in two years.
- Gains of $500,000 for taxpaying couples filing jointly, and $250,000 for single filers, are excluded from tax liability.
- It is optional for time spent living there to be concurrent.
Requirements & Rules under IRC§ 121
IRS Section 1031 stipulates that investors may only defer capital gains tax via a 1031 exchange if the property was held for business or productive purposes, such as a rental investment property. However, the Internal Revenue Code Section 121, otherwise known as IRC §121, is one way homeowners can defer capital gains tax when selling their primary residences. Under section 121, the taxpayer must meet specific rules in order to qualify for the exclusion, such as:
- Ownership for at least two years out of five years before the date of sale
- Use of the primary residence as a main home during these two years
- Bona fide intent to use the primary residence as the main home
- Maximum exclusion of gain is limited to $250,000 per individual or $500,000 per married couple filing jointly.
Additionally, there may be unique tax implications if multiple homes were owned within two years before the sale. These factors should be considered when deciding how best to approach a potential deal. Qualified tax advisors should always be consulted for advice related to taxes.
Section 1031 Functions
- Tax deferment
- If you want to defer paying capital gains tax, you must reinvest all of the earnings from your transactions.
- To be kept for commercial or investment reasons, replacement property and relinquished property must be a like kind property
- The 45-day verification period, the 180-day replacement period, and the employment of a certified intermediary are just a few of the regulations that must be followed to complete a 1031 tax-deferred exchange.
- There is no maximum number of times a Section 1031 exchange may be used.
- Boot, also known as sale profits, is taxed as a capital gain.
Timeframes for 1031 Exchanges
According to the IRS, you have 45 days from the time the old property transaction closes to either finalize the acquisition of a new property or formally designate the property you want to buy as a portion of the 1031 exchange.
Identifying your replacement properties and selecting your certified intermediary before starting the 1031 exchange procedure can help to stick to these rigid timelines. After surrendering your old property, you have 180 days to buy at least one replacement property to finalize your 1031 exchange. In the event that you select more than three properties, their combined value cannot exceed more than 200% of your relinquished property value.
Final Thoughts: Executing a 1031 Exchange on a Primary Residence
While you cannot directly carry out a 1031 exchange on a primary residence, there are other provisions that help investors defer capital gains or losses. This is why NNN Deal Finder strongly advises that you put together your team of experienced advisors. We educate, enlighten, and connect real estate investors with the most trustworthy NNN Properties for sale, continuously producing passive income. We are experts in 1031 exchanges and can assist you throughout the whole procedure, from preparation to closure and beyond.