How Does Home Equity Loan Impact 1031 Exchange?

[Account Closed]

Good afternoon! I have a question that I am hoping you or if you know someone that can help answer. If I decide to do a home equity loan on my primary residence and then convert it into an investment rental property next year but still expect to hold it for at least 5 years, how will that impact my 1031 exchange? Let's say if I have $360K mortgage balance now and when applying for a home equity loan, the appraisal comes back with $700K market value. That being said, I would be allowed to take out $165K cash based on 75% LTV. My debt would increase from $360K to $525K. Then when I decide to execute 1031 exchange, I wonder how does my home equity loan impact the value I must carry over to my replacement property? What's the value I will be required to spend on my replacement property? $700K ($525K debt and $175K equity) or $535K ($360K debt and $175K equity) after paying off the home equity loan in full at closing? I have not been able to find an answer to this question. Your help is greatly appreciated.

[Dave Foster]

@Account ClosedThat proration between qualified and non-qualified use comes from the Housing Assistance Tax Act of 2008 and is used when a property has been converted from a rental to a primary residence not from primary residence to rental.  And if the property has been converted from rental to primary and was previously part of a 1031 exchange there is the added requirement that you have owned the property at least 5 years.

You will have to recapture depreciation on the time when your property was a rental but after that recapture you will be eligible for the entire primary residence exclusion.  That's why that 5 year window is so key when converting from a primary to rental.  You're getting 3 year of appreciation and rental income essentially for free.