There are many reasons an investor may wish to convert an investment property into a personal residence. If you no longer want to hold your 1031 exchange property as a rental property, you have options. As long as you abide by the Internal Revenue Code (IRC), converting investment property into a principal residence is not difficult.
Before repurposing your investment property, contact a specialist in 1031 exchange conversions. At NNN Deal Finder, these real property experts have facilitated numerous investors in optimizing their rental properties for personal use and business purposes alike.
If you’d like to turn your 1031 tax-deferred exchange property into a primary residence dream home, you have options.
Why Turn Your 1031 Exchange Investment Property into a Primary Residence?
There are many reasons to convert a like-kind investment property into a primary residence. Some of them may occur suddenly and unexpectedly, and others happen more naturally.
Whether a financial situation, an interpersonal development, a health event, or some other reason, you reserve the right to transition your 1031 exchange property from a property used for investment purposes to one used as a primary residence. However for compliance reasons, this is not advised immediately after you acquire the property.
The following reasons commonly explain the conversion from an investment property to a primary residence:
- Loss of job or career
- Spousal issues (i.e., divorce)
- Health issues or injury
- Getting married
- Caretaker responsibilities (i.e., elderly parent)
You must always maintain paperwork related to these life-changing events in case the Internal Revenue Service (IRS) inquires. Each of these cases can qualify as an important exception. You will also need to demonstrate that when you did acquire the property, it was for business or investment purposes. Proving investment intent will keep you in adherence with the Internal Revenue Code.
How to Convert Your 1031 Rental Property into a Principal Residence
As with any actions taken through a 1031-like-kind exchange, you’ll need to ensure you are abiding by all known property laws, rules, and regulations. Be certain that the investment property you plan to convert has been used for investment purposes for the specified period and that your personal use has not exceeded a maximum level.
What Many Investors Don’t Know About the 1031 Exchange Challenge
If your property history, intended property use, and reasons for such use are not clear, the IRS may issue a 1031 exchange challenge. If this happens, the IRS may determine that your rental property was not actually a rental property, or that your reason for converting it to a primary residence is insufficient.
Whether it’s a relatively new property or a much older exchange property continuously used for non-primary residence purposes, the property must ‘pass the test.’
The criteria for any property in a residential investment portfolio, from a single-family home to an apartment, are as follows:
- The real estate was purchased and held for investment/business purposes to be rented to potential tenants (i.e., if a couple rents).
- The real estate was rented out at a fair market value rental rate for at least 14 days each year.
- The property has been held for at least two years after the 1031 exchange sale. This is called the qualified use period.
- Your personal use following that sale has not exceeded either 14 days or 10 percent of the number of days the property was rented during a 12-month period.
Remember, once you acquire an investment property in a 1031 exchange sale, you cannot rush into converting it to a primary residence. A three-year rental period may give you some extra cushioning, as this time rented indicates your investment intent.
What You MUST Know Before Converting a Replacement Property into a Primary Residence
You likely used the 1031 exchange for several key reasons. Firstly, you wanted to defer capital gains tax and depreciation recapture. You also knew that by having estate plans drawn up, you could smartly defer capital gains taxes indefinitely. Each 1031 exchange replacement property could be more lucrative than the old property.
Even with a converted property, you can still enjoy this deferral.
Continue Deferring Capital Gains Taxes While Converting to Your Principal Residence
Again, you can continue to defer capital gains taxes even if you convert your most recent exchange replacement property into a primary residence. It all depends on two main factors: (1) the amount of your total gain based on accurate calculations, and (2) if you can pass ‘the test.’
Although showing business intent is not a new limitation or requirement, there are multiple ways to demonstrate this to qualify. So set the example. By demonstrating your intent and use in multiple ways, you can pass the “safe harbor test” with flying colors.
How to Pass the Safe Harbor Test for a 1031 Exchange Investment Property
If you relinquish an old property and acquire a property for investment purposes, this so-called test helps determine whether that dwelling unit does, in fact, qualify as property held for productive use.
If you want to stay essentially tax-free, (or rather, tax-deferred) under the 1031 exchange treatment, you should always be wary of the laws when you acquire property.
How to Prove Productive Intent in a 1031 Exchange
- Delay any construction or renovation on the property after the purchase.
- Avoid moving into the house for ANY reason, even temporarily.
- Have paperwork showing how you calculate your rent price.
- Have copies of advertisements/listings at fair market value.
- Document any reason why you need the property as a personal residence.
- Preserve contact information for potential tenants.
Just remember: the IRS will look closely at your 1031 exchange property as they do all replacement properties. If you are unsure about demonstrating rental purposes or that it was a rental prior, consult an expert in 1031 exchange requirements.
Whether you’re selling, buying, or converting, a 1031 exchange specialist can keep you in perfect compliance with all related tax and property laws. Once you have converted to a primary residence through the 1031 exchange, you may be able to take advantage of Section 121.
Using Section 121 for Excluding Gain from Taxable Income
If you don’t want to pay taxes where you don’t have to, the Section 121 exclusion is very useful. Under Section 121, you can exclude as much as $250,000 from taxable gain when you sell your principal residence. It’s even better if a married couple sells their house.
For married couples, that figure can reach up to $500,000.
However, don’t sell blindly thinking you won’t have to pay tax. There are specific tax criteria for enjoying this primary residence exclusion.
Before selling, ensure that you have met the following conditions in a five-year period:
- Owned the home
- Used it as a principal residence for 24 months or more
Under Section 121, the five-year period concludes the day you sell the property. The 24 months can be separated, and do not need to be consecutive. Have extensive paperwork to prove you owned the home and were living in it. For example, a deed or utility bills.
Be cautioned there are always exceptions. For example, the Housing Assistance Tax Act of 2008 may affect certain investors who converted a 1031 exchange property into a primary residence.
Whether you’re dealing with a vacation home, apartment, long-time investment, or any other real estate, always consult a 1031 exchange expert for help.
Your Trusted 1031 Exchange Specialists
At NNN Deal Finder, our network of owners, developers, and brokers help investors find the most reputable, brand-name commercial properties for lucrative, predictable cash flow. Our 1031 exchange specialists have helped many investors defer capital gains on their properties and enjoy a truly passive income.
If you want to learn how to convert a 1031 property into personal property, give our experts a call today, and we will walk you through the process.