Length of rental period when converting primary residence TO rental for 1031?

Question

Hello everyone!

From what I've gathered, when converting a property acquired via a 1031 to a primary residence, one needs to be very careful to not trigger tax consequences by rkeeping the newly acquired property for at least 2-3 years as a rental.

However, I'm not seeing much information about the reverse scenario - when a homeowner wants to convert his/her property to a rental with the intention of doing a 1031 exchange ASAP (say, to increase ROI by converting a SFH to a multi), what's the length of time the property needs to be rented for it to be considered an investment?  6 months? 1 year?

Thanks!

Bill Exeter · Answer

The Treasury Regulations do not provide for any specific holding period.  They merely require that you have the intent to hold for rental or investment purposes.  I think the comment above about renting for only 3 or 4 months is very dangerous.  It is very difficult to prove intent in those circumstances unless you have some pretty good documentation to support the intent to hold for investment purpose and to explain the short holding period.

Twelve months should straddle two tax years/returns and go quite a ways in demonstrating intent.  Those who wish to be more conservative might choose to rent for 24 months or longer.

Our website does not say that 12 months is sufficient, but 12 months or longer.  If the 1031 Exchange is "plain vanilla" the 12 month hold might be sufficient, but if it is "pushing the envelope" then 24 months might be better.  These are opinions since there is nothing in black and white.

Bill Exeter · Answer

Hi Layla,

You can combine the 121 Exclusion and 1031 to defer all of your taxes.  The Internal Revenue Service issued Revenue Procedure 2005-14, which allows you to move out of your primary residence and convert it into investment property. The question is: how long must you hold the property as investment property?

Based on Revenue Procedure 2008-16, we recommend that our clients hold the property for investment for at least 24 months or more, to demonstrate that they have the intent to hold for investment.

Once you have held the property for investment for at least 24 months, you can sell it and qualify for a combined 121 Exclusion and 1031 Exchange strategy.

You would sell the property, exclude the full $500,000 in capital gains (as a married couple) from your taxable income, and complete a 1031 Exchange on the balance of the transaction to defer the rest of your capital gain, including any depreciation recapture, into the purchase of another rental property. This tax planning strategy must be completed no later than three years from the date that you moved out of your primary residence and converted it into investment property.

Layla Savant · Answer

Bill, unless I'm reading this incorrectly, doesn't it advise on your firm's website that 12 months is sufficient?

"

Primary Residence Converted to Rental Property

The final scenario consists of you (and your spouse,  if applicable) owning, living in and using a property as your primary  residence.  The challenge is that  your capital gain significantly  exceeds the $250,000.00 (or $500,000.00) tax-free exclusion permitted  under the 121 exclusion, and if you sell your property the amount of  capital gain that exceeds the 121 exclusion limitation would be  painfully taxable.

The Internal Revenue Service issued Revenue Procedure 2005-14,  which allows you to move out of your primary residence and convert it  into investment property.  The question is how long must you hold the  property as investment property?  Exeter recommends holding the property  as investment property with absolutely no personal use for at least 12  months or longer in order to demonstrate that you did in fact have the  intent to hold the property as investment property.  Once you have held  the property for a sufficient period of time, you can sell the property  and qualify for the 121 tax-free exclusion and for a 1031 exchange so  that you can defer the balance of the capital gain into more investment  properties.

You would sell the property,  exclude the $250,000.00  or $500,000.00 in capital gains from your taxable income and complete a  1031 exchange for the balance of the sale transaction to defer the rest  of your capital gain, including any depreciation recapture, into the  purchase of another like-kind rental property.

It is a great income tax planning strategy when you have a highly appreciated primary residence."

Layla Savant · Answer

@Bill Exeter    and @Dave Foster Thanks for the information.  And Bill, those tips about combining the homeowners and the 1031 are invaluable and probably the route I will take.

Interestingly, my tax accountant said that any number of months on a single tax return would be fine.  So, if I rented from Sept to Dec and sold in Jan, that would be fine as I would show on my '15 taxes a few months' rental income.

This is wildly different from what I've heard before - which has always been two years.  I'd love to bail out on this property as soon as possible, but don't want to trigger any unnecessary taxes, of course.  I tried calling the IRS and they don't seem to have any live reps anymore! ;)

Dave Foster · Answer

@Layla Savant, I'm not a fan of using narrowly based rev procs in broad applications. They're not meant to be used that way.  However  there is a hidden gem in rev proc 2008-16 that was missed earlier and that is that if you adhere to it prescriptively you really need only hold the property as rental for 13 months not 24 months as was suggested.

your accountant is relying on one of the specific wordings from a tax court decision that two tax years is appropriate.  Two tax years does indeed separate the purchase  (or in your case the placing into service) and sale of a property.  There have been many successful exchanges following this line of reasoning but it too should not be applied as an umbrella over all.

The truth of the minimum time the property needs to be rented after conversion from primary residence to full time rental lies not in a specific time but rather with your demonstrable intent.  There is no statutory holding period.  In this you would be wise to work with your accountant to use documentation to memorialize your intent to "hold the property for productive use in business trade or for investment".

Chad Morris · Answer

I know this is an old topic but I have a question I can't seem to find an answer for. Say I've owned a 3 apartment  investment property and I'm going to sell it. It's been fully rented for the last 8 years. If I sell it and but a single family home that I plan to make my residence in the future. How long do I need to rent the property out before I can technically move into and avoid paying capital gains?

Vincent Polisi · Answer

@Layla Savant he's got gains of over $250k or $500k on his primary residence?Remember, gain on sale is based off of his basis in the property, not how much cash he walks with because he has no mortgage. I wasn't aware that California had recovered to the point that someone could have that type of gain on a primary residence unless he bought it 20 years ago or at the bottom of the crash.

Obviously, pre-2008 that was the norm.

Even so, why would he want $250k or $500k taxed unnecessarily? I don't get that.

Vincent Polisi · Answer

@Layla Savant, an owner occupied primary resident would be foolish to convert his property to a rental for the purpose of doing a 1031 exchange. Here's why:If the owner has lived in the home 2 out of the last 5 years, he gets a $250k capital gains exclusion if single and a $500k capital gains exclusion if married. What this means is that he can make a profit of $250k or $500k tax free simply by selling it if he's lived in it 2 of the last 5 years. The 1031 would serve no purpose.

But, to answer your question, it depends. The length of time to be considered an investment property depends on who you're talking to. For example, the minute he no longer occupies the property and has a tenant in place paying rent, it's an investment property. Lenders, however, won't generally classify it as an investment property for debt to income ratio purposes until there's 12 months of seasoned rental payments or more AND it's declared on his tax return as an investment property.

Layla Savant · Answer

And the plan is to have real estate investment become a large port of the portfolio; hence the interest in a 1031 exchange and probably add'l 1031 down the road.

Layla Savant · Answer

Yes, the purchase was made several decades ago.

Length of rental period when converting primary residence TO rental for 1031?

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