Converting 1031 property into a primary residence

[Dorian Gray]

I’m considering getting out of real estate investing. The thought came to mind of selling my properties (4) and getting a single family residence, renting that out for a couple years and then moving into it, converting the property into a primary residence and then after living there for a few years selling it, hoping to not pay taxes on the gains since it is a primary residence. Is this legal? Is it capable of being done?

[Whitney Nash]

Hello @Dorian Gray

As others have stated, it is possible to do this and it is legal as far as capital gains tax is concerned, (and again, depreciation will still need to be recaptured). You just want to make sure that you take into consideration and keep track of the time that you live in the property for personal use after it being a rental for the obligatory amount of time because the proration is viewed differently since it will be a 1031 replacement property instead of living in it first and renting it out after. Two things are taken into account when determining the amount of cap gains that can fall under the 121 exclusion: the amount of time it is lived in personally and the amount of gain on the property. Here is an example to help you see the numbers:

When someone files their tax return and completes the worksheet to determine if there is a taxable gain, it asks if there was 'nonqualified-use' (non-use) time before it was 'qualified-use' (personal-use). As I stated, the amount of gain and the amount of time it was personal-use after it was non-use matters. If you live in it for 5+ years after the non-use period ends, then you'll get the full benefit of the 121 exclusion no matter the amount of gain, up to the limit ($250k or $500k). If it was personal use between 2-5 years, then you can only claim a portion of the 121 exclusion depending on the amount of gain. So, the longer it is personal-use, the more you can exclude. Also, the higher the gain, the more you can exclude. Here are two scenarios: If you have $1m or more in gain, then you can get the full $500k (MFJ) exclusion even if you only live in it for 2 years. If you have $250k of gain and live in it for 3 years after 2 non-use, then you can only exclude $150k of the gain.
(This was determined by running hypothetical scenarios through Worksheet 3 of IRS Publication 523 (2021) and is for illustrative purposes only.)