What is a 1031 Investment Property?

Posted by Angilina on October 9th, 2019

A 1031 exchange enables an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long as another “like-kind” property is purchased by reinvesting the proceeds from the sale of the investment property, known as the “relinquished property”, into a qualified “replacement property”.

A 1031 investment property typically involves property that you hold for investment, and not your personal residence. The investor must acquire a replacement property or properties that are of equal or greater value than their relinquished property (including any loan pay off), reinvesting all net proceeds (equity), and following the IRS required guidelines and time-frames. But can you convert a 1031 exchange property to primary residence? Let us find out here.

Steps to convert a 1031 investment property into a primary residence

By definition, a primary residence does not meet the qualified purpose that is required for a 1031 exchange. A primary residence is not a property held for investment or for use in a trade or business. The key point is your intention when you acquired the replacement property. 

If you sincerely intended to treat it as an investment property then you should have no problem. But it is hardly possible to prove your intent. The best thing to do is to actually use the property for investment purposes for a time period after its acquisition. For at least a year, you should rent the house out at a fair market value which will enable you to prove that you acquired the property with investment intent.

IRS has also provided guidelines for determining how long a replacement property must be held as a rental before converting it into a primary residence or vacation home.

Rules about the qualifying period

Immediately after the exchange, the replacement property must be owned for at least 24 months, which is the qualifying period. The taxpayer must follow certain rules in each of two 12 month periods which are:

1. The taxpayer must rent the replacement property to another person at a fair rental for 14 days or more.

 2. The taxpayer’s personal use of the replacement property must not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.  It can be rented to a family member as a principal residence so long as market rent is paid.

Here you can also qualify for a Section 121 exclusion of gain, however, to do that you must use the home as your primary residence for at least 2 of the last 5 years prior to its sale. Furthermore, there is a special rule of section 121 for 1031 property, it states that you have to own the home for at least 5 years (either as 1031 property or primary residence) before you sell it. Finally, the amount of the exclusion you can claim will be prorated between the period of time it was your principal residence and the time that it was not and any depreciation you took will be taxable.

A valuable tool for real estate investors

Every individual’s case is different with different facts and circumstances. So before you get down to the path of converting a 1031 exchange property to a primary residence, contact a professional. Professionals in the business of exchange will provide you solutions that best satisfy your needs.