1031 Exchange - rent for 2 years and then switch to primary residence

[Ben T.]

Hello - I have a rental property. If I sell it in 1031 exchange, can I then get another rental, rent it out for 2 year and then make it my primary residence i.e. homestead and that way avoid any depreciation recapture and capital gains?

Also what are 1031 exchange fees?

[Jason Watson]

Theoretically, Yes. Keep in mind that a valid 1031 exchange relies on business to business "mindset." So, I would keep your 2-year plan to yourself. In 2 years, sure, have a change of heart. But it should not be "the plan" at the time of exchange.

[Dave Foster]

@Ben T., Yes you can.  There is even a safe harbor from the IRS in Rev Proc 2008-16.  That conversion will not trigger any tax.

Unfortunately we can no longer eliminate all of the tax simply by converting to a new primary and living there.  Here's a synopsis:

1. You must have owned the new property for at least 5 years.

2. You must have lived in the property for at least 2 out of the 5 years prior to selling it.

3. You will then get to prorate the gain between the number of years you lived in it (tax free) and the years it was a rental (pay the tax).

4. And you do have to recapture depreciation

But all in all this can still be a wonderful move to eliminate at least a part of the gain.