1031 exchange followed by a move in?

Question

If we sell rental property A and buy a similar rental property B, can we move into it after renting it for a while (say, 1 year)?

Let's say we sell rental property "A" in 2020 with 500K profit but do it as a 1031 exchange and buy a similarly priced property B.  No taxes are paid.  We rent B for a year then move in and live in it for 9 years.  It appreciates significantly and we sell it in 2030 with 500K profit.  Can we (a married couple living together in B as primary residence and filing jointly) get 90% of that 500K profit tax free (only 90% because we rented it for 1/10 of the time).

What happens with the 500K profit from property A? .  Is it tax free?

Brian Sparr · Answer

Hi @Peter Ivanov -

Yes, you are allowed to move into your rental property and consider it your primary residence.  However, you should be careful with how soon you move into the property after completing the exchange; otherwise, you risk invalidating the exchange.

A 1031 is deferring the taxes - not eliminating them (putting aside proper estate planning and you holding the property until you die).

Accurately working through these types of scenarios can be tricky because of all the moving parts - ie, recapturing depreciation, adjusting the cost basis, whether you owned the property prior to 2009, etc.

However, if we generalize this and ignore the tricky parts for the time being, you could have this scenario play out like this:
- buy property A in 2010 for $500k
- sell property A in 2020 for $1M and exchange into property B (deferring $500k of profit)
- rent property B for 1 yr and then move into it as primary residence
- sell property B for $1.5M in 2030 (another $500k of profit)

To figure out your taxes, you'd be looking at:
- a total of $1M in capital gains ($500k from sale of prop A and $500k from sale of prop B)
- you owned props A and B for a total of 20 yrs - 9 of which were as your primary residence (45%)
- this limits your potential primary residence exclusion to $450k ($1M x .45)
- since you're married filing jointly, you can exclude the entire $450k (but not the max of $500k)
- the remaining $550k would be treated as long term cap gains

Again, this is very generalized and not meant to be an accurate calculation, but hopefully gives you an idea of how the numbers might work out.

Best advice any of us can give you here = consult with your tax professional :)

Good luck,- Brian

Dave Foster · Answer

@Peter Ivanov, There's a relatively easy way to think of the impact of the 1031 that may help your understanding as a whole.  The actual mechanism of the 1031 is that your adjusted cost basis in the old property transfers into the new property.  And your adjusted cost basis includes all elements including depreciation and capital improvements.

In your scenario you purchased your old property for $500K and sold for $ 1mil.  and 1031d into a new $1 mil property.  Because of the 1031 your basis in the new property is the $500K basis of the old property.  So if you sold your new property the day after you complete your 1031 for exactly what you paid for it the day before you would still have a $500K gain.

So, your basis then when you move in to the property after a year or so is still going to be the $500K (minus another year or so of depreciation).  The clock will then start ticking on your use of the property as your primary residence.

When taking advantage of the primary residence exclusion of sec 121 on a property that has been converted from investment and was part of a 1031 exchange there are some additional requirements.

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

2. You must have lived in the property for 2 out of the 5 years prior to sale.

3. You will only get to prorate the gain between the periods of "qualified use" (as your primary residence) and "non-qualified use (as investment) (we'll have to ignore for the example your holding period of property A).

4. You have to recapture all depreciation

So, to your example - Will you have owned the property for 5 years - yes you owned it for 10

Did you live in it for at least two of the five years prior to sale - yes you lived in it for 9 of the 10 years you owned property B.

So you get to prorate the gain up to the full amount of the $500K..  But several years were also non-qualified use of property A.  So most accountants are going to make you take those years as "non-qualified use". So I'm guessing you won't get 9/10ths of the gain tax free.  You'll get 9/??ths (including the period of rent for prop A).

And then lastly again you'll have to recapture whatever portion of that gain is depreciation.

You'll pay a little tax.  But you'll get a heap tax free as well.  Still a very good strategy.

Bob Norton · Answer

@Peter Ivanov @Brian Sparr You will get the full $500k exclusion after converting your 1031 exchange property to a personal residence and living in it for at least 5 years [IRC Sec 121(d)(10)].  So, in the above scenario you would receive a $500k exclusion since you lived in it for 9 years and then you would pay capital gains tax on the remaining $500k (the deferred gain from the exchange), plus you would pay tax on depreciation recapture for the years that you depreciated the property for use as a rental.

1031 exchange followed by a move in?

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