1031 exchange now plus $500k tax exclusion later

[Michael Plaks]

@Julie Dib asked me on another thread:

"my father in law just sold a rental in Cali he’ll have about $300k in capital gains, if he were to 1031 exchange that money into a new rental property and plan to eventually live in it, how long does he have to rent it for before he lives in it? And how long does he have to live in it in order to sell it as a homestead and not pay capital gains?" Julie clarified that "...he just accepted an offer- not sold yet, needs to ID a property now..."

There're a few issues here.

1. I hope your father-in-law already engaged a QI - qualified intermediary for the exchange. If not, he needs to do it ASAP and absolutely before the closing. @Dave Foster, our local 1031 expert and a QI, will gladly fill in the details.

2. When you do a 1031, you have to exchange it for an investment property, not for your future residence. You can exchange into an investment property, rent it for some time and then later decide to move in yourself. This is not breaking any rules. However, you already have an intention of moving into it, and it pushes this into grey area. So, what you're essentially asking is how long you have to wait before moving into it in order to conceal that it was the purpose of the exchange. There is no specific waiting period prescribed by tax law to establish the new property as an investment property. There're some rules of thumb that I will leave for Dave to lay out. He will get upset if I steal his thunder. :)

3. You have another problem that was described by @Bill Brandt on the other thread: non-qualified use. Basically, if your father-in-law acquires a rental property via an exchange, rents it for some time and then moves in for 2 years - he will not get the full capital tax exclusion when he sells it, only a prorated exclusion. The calculation can get tricky, especially with a 1031 involved, so get him some professional help.

4. One additional quirk: your father-in-law should not sell the new property for 5 years after acquiring it, regardless of the date he moves into it, in addition to all other requirements for the exclusion.