Converting 1031 Exchange Property Into Primary Residence

Added June 7, 2007 by Ilyce R. Glink

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Summary: When using a 1031 exchange to convert investment property into a primary residence, a homeowner must wait at least three years. Before converting from an investment property to a primary residence, make sure you understand the IRS rules to shield capital gains tax.

Q: In a recent column, you advised the reader that a 1031 property needs to be rented for 3 years prior to moving into as a primary home.

I have not seen any authoritative source which quantifies a 3-year use period. The closest thing I've found is IRS Publication 544, which states that if a property is held for more than 2 years, the predominant use will be evaluated for 2 years. If the property is held for less than 2 years, the predominant use will be evaluated during the entire holding period.

Several of my clients read your article and called questioning the 3-year period mentioned in your article. I realize a 1031 property converted to primary use now has a 5-year holding period to afford the taxpayer a Section 121 exclusion.

Were you alluding to this ruling? As a Qualified Intermediary it is important for us to give accurate advice to our clients. Thank you for your time.

A: Many people are interested in buying investment property and then later converting it to personal use in order to shield some of the capital gains.

From the investment side perspective, an owner can defer paying taxes on the sale of an investment property by utilizing a qualified intermediary in a 1031 tax free exchange of properties. That is, the sale of one investment property for another while following strict rules under IRS code section 1031. If you sell an investment property and replace it, some experts in 1031 advise their clients to hold that replacement property for two years and continue to use it for investment purposes during those two years.

On the other hand a homeowner that has used his home a primary residence for two out of the last five years is able to sell it and exclude from taxes $250,000 of gains (or $500,000 for married couples).

Using these two general rules, leads to my comment on the 3-year holding period. For purposes of the tax exclusion on the sale of a home, a homeowner could only have rented a property a maximum of 3 years out of five to qualify for the $250,000 exclusion ($500,000 for married couples).

Since you have to use property as a personal residence for at least two of the past five years, using the property for three years as a rental would seem to make some sense. According to a qualified tax intermediary I spoke to, you could live in the home as a personal residence for at most three years, after using the property for at least two years as a rental and still fall within the guidelines of both rules. Thanks for taking the time to write.

Published: Jun 7, 2007

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