How Would You Structure A 1031 on a Primary?

Question

If my wife and I own our own house which have appreciated well over 1 million, and I would like to use a 1031 exchange in order to defer taxes -
I have these questions, let's assume we purchased it for $1 million, and it's now worth 2 million dollars and I lived in it for the past 3 years as my primary residence.

1. Will I still be able to use the $250,000 per spouse exemption on the appreciation, and how will this impact my 1031 exchange?

2. In order to benefit from a 1031 exchange to defer my taxes will I need to convert my primary residence into a rental property and if I do, what's the minimum amount of time that I need in order to hold it as a rental to make sure it qualifies for a 1031 exchange?

3. Say we rent it out for 1 years after we move out - will the defer amount in the exchange be our entire appreciation? only the appreciation gained during the leasing period? and how will the $500k exemption play into it?

Dave Foster · Answer

@Dani Beit-Or.  There's a way to make this work.  But it will take a little runway.  In order to qualify for the primary residence exemption you must have lived in the property for at least 2 out of the 5 years immediately prior to selling it.  You will get the $500K tax free.

To do a 1031 exchange you must be selling an investment property.  And then you will purchase a new investment property and all of the gain is tax deferred indefinitely as @Jaron Walling said.

The way to combine and get both advantages would be to move out and turn that property into an investment property for a year.  Then sell it.  You're now selling an investment property.  So you can do a 1031 exchange.  You will take $500K in boot from the 1031 exchange.  Normally this would be taxable.  But since you have lived in it for 2 out of the last 5 you would get that $500K tax free.

You set up a situation where you qualify for both.  Pretty awesome stuff!!

Dave Foster · Answer

@Dani Beit-Or,

Yes, since you're taking some profit (the primary exclusion) out that would reduce your reinvestment requirements by that much.

the 1031 exchange will defer all of the remaining gain and the depreciation recapture.

In your situation, you will have a total profit of around $1.5.  And depreciation taken of say $50K.  Total gain then is $1,550,000.  If you take the $500K for the primary exemption (which will end up tax free) then you have a total gain left to defer of $1,050,000.  As long as you purchase at least $2 mil in real estate using all of your remaining cash proceeds (after the $500K primary) you will defer all of the tax on that.

Jackson Hanssen · Answer

@Dave Foster with the great answers and insight yet again.@Dani Beit-Or yes that reduces the exchange amount from 2.5mm to 2mm. You only roll over the 2mm, take a 500k cash out and then claim the 500k sec 121 exemption.You can think of it like taking the 500k off the top, then the remainder functions as a normal 1031 exchange would.

Dani Beit-Or · Answer

@Jaron Walling - Thanks for the answer!

@Dave Foster, thank you for the detailed info! I understand your points, but I want to clarify the tax consequences in my example. I’m simplifying the numbers here to focus on the main concept, so I’m leaving out factors like expenses, improvements, property management, repairs, etc., for now.

Here’s the scenario:

- I bought my house in 2022 for $1MM and used it as my primary residence.

- In 2024 (after 2 years), I moved out and converted it into a rental. At the time, the house's estimated market value was $2MM.

- By summer 2025, I plan to sell it. Let’s assume I can sell it for $2.5MM, net after sales expenses.

In a straight 1031 Exchange, I would sell the property for $2.5MM and need to exchange into another property (or properties) of equal value to fully defer taxes.

My questions:

1. Since I have the $500K exemption, does that reduce the exchange amount from $2.5MM to $2MM? Or do I still complete the 1031 exchange for the full $2.5MM, with the $500K deduction only reducing the deferred tax owed?

2. Also, does the 1031 exchange cover just the $500K gain (appreciation since converting to rental) or the full $1.5MM gain?

Thanks for helping me understand how the $500K exemption interacts with the 1031 Exchange!

Jaron Walling · Answer

@Dani Beit-Or It's my understanding you can't 1031 exchange a primary residence. Even if you could it all you're doing is deferring taxes instead of eliminating them. There is no minimum holding period for a 1031 exchange property (if you tried), but many investors recommend holding for at least two years to avoid scrutiny. The IRS focuses on intent rather than a specific minimum holding period.The benefits of the primary exclusion out way renting your primary, deferring, and doing a 1031 exchange. You also have PM, repairs, vacancy, and capex on rental property. When you bake in those expenses renting makes no sense unless the cash-flow is insane.

How Would You Structure A 1031 on a Primary?

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