Rental properties acquired in a 1031 exchange can be converted to the taxpayer’s primary residence. This is a popular strategy that allows taxpayers to live in their vacation property. The question is how long does the property need to be held as a rental before conversion? The answer depends on the circumstances.
1031 Exchange
A rental is often acquired as a replacement property in a 1031 exchange. 1031 exchanges are a tax deferral strategy recognized by the Treasury Department and the Internal Revenue Service (IRS), also known as Section 1031. The Code states “no gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.”
No gain refers to the recognized gain or tax when a property is sold. No tax is due if the taxpayer follows the 1031 exchange rules. Make no mistake, the tax obligation does not go away, but rather is postponed until the replacement property is sold. Property refers to real and personal property held for use in a business or investment. Real property can be exchanged for any real property while personal property must be exchanged for like kind or like class personal property.
The phrase “held for productive use” implies limited personal use. The word “held” suggests time to allow the property to season as an investment or for use in a business. Flips are not eligible for 1031 consideration. Flips are when property is held for sale similar to inventory on the shelf.
Revenue Procedure 2008-16
In March, 2008, the IRS published Revenue Procedure 2008-16 for like-kind exchanges of rental property used for personal purposes. The procedure provides “a safe harbor under which the Service will not challenge whether a property that is rented to others but also occasionally used by the owner for personal purposes qualifies as property that may be exchanged in a like-kind exchange under section 1031 of the Code.”
Both the relinquished and replacement property qualify as property held for productive use in a trade, business or investment if the dwelling unit is owned by the taxpayer for at least 24 months immediately before and after the exchange and in each of the four 12 month periods, the property is rented to another person or persons at a fair rental for 14 days or more. Personal use is not to exceed 14 days or 10 percent of the number of days during each of the four 12 month periods.
Tax Court cases Goolsby v. Commissioner, TC Memo 2010-64 (April 1, 2010) and Reesink v. Commissioner, TC Memo 2012-118 (April 23, 2012) offer additional guidance regarding good supporting facts for converting rental to personal use after acquiring in a 1031 exchange. In Reesink, the taxpayer converted their rental to a primary residence after seven months and the Service allowed their 1031 exchange to stand given the fact pattern.
To be safe, two years is the recommended time to hold prior to converting to a primary residence. The taxpayer then has the benefit and safety of the safe harbor provided by Rev Proc 2008-16. A shorter hold could subject the 1031 exchange to a review.
Conversion Supporting Facts
A good fact pattern supporting the intent to convert a rental to a primary residence includes:
- Two year hold as a rental
- No longer reflecting the rental on Schedule E of the taxpayer’s return
- Receiving mail and registered to vote at this address
- Children attend school from this address
The deferred capital gain can be absorbed by the Section 121 $250,000 exclusion for individuals and $500,000 filing as married if the property is held for five years. The non-qualified use or the two years (two fifths of the five years) held as a rental and the recaptured depreciation does not qualify for exclusion when selling as a primary residence.
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