Taxpayers who have acquired a rental property in a 1031 exchange can convert it into their primary residence. Conversion typically occurs when the taxpayer’s Driver’s License and voter registration reflect the new address. The newly converted primary residence is also no longer reported on Schedule E on the taxpayer’s 1040 return, rather on Schedule A. In addition, three issues are to be considered prior to the conversion.
1031 Exchange Impact
How will the conversion impact the 1031 exchange? As you recall, a 1031 exchange is a tax deferral strategy that allows taxpayers who sell property held in a trade, business or for investment to replace with property of equal or greater value. The 1031 exchange outcome is the potentially indefinite deferral of the federal and state capital gains tax, along with recaptured depreciation. The deferral is recognized by the Treasury Department and Internal Revenue Service (IRS) under Code Section 1031.
The tax obligation does not go away, rather is postponed until the replacement property sale. In the case of a rental property converted to a primary residence, the property must be held for at least five years for the qualified gain to be eligible for the Section 121 $250,000 for filing as an individual or $500,000 filing jointly as married taxpayers. This means that after five years of holding the converted replacement property, the qualified deferred gain representing the time the property was held as a primary residence and not the non-qualified gain the time the property was first held as a rental property qualifies for a partial Section 121 exclusion.
For example, an individual taxpayer with adjusted gross income under $200,000 residing in South Carolina with a 7 percent state capital gains tax acquired land for $50,000 and later sells for $200,000 with $10,000 of selling expenses. The replacement property is a vacation rental purchased for $200,000 with $40,000 of improvements. The rental property is managed by a vacation rental management company for two years. At the end of two years, the property is converted into taxpayer’s primary residence and later sold in year six for $300,000 with $15,000 of selling expenses.
The initial exchange results in a realized gain of $140,000 with the land’s sale triggering an estimated tax of $30,800. After five years, the primary residence is sold with an estimated realized gain of $196,982. Given Section 121 exclusion does not apply to the depreciation of $6,982, the total realized gain is $190,000, representing a tax of $41,800. Two-fifths of the time the replacement property was held as a rental so only three-fifths of the gain ($25,090 or 60 percent) is eligible for the exclusion while the remaining $16,720, or 40 percent, is the tax due. If the time held as a primary residence is seven years rather than three, the Section 121 exclusion absorbs five-sevenths ($29,857 or 71 percent of) the gain while $11,943, or 29 percent, is due, plus the $6,982 depreciation.
Personal Use
Section 280A of the Internal Revenue Code provides the definition of rental property personal as not to exceed 14 overnights per year or 10 percent of the actual days rented to qualify as investment property. Otherwise, the property begins to assume the character of a second home. Overnights spent while performing maintenance or repairs do not count towards personal use. Use by related parties including brothers, sisters, spouse, grandparents and grandchildren are deemed personal use per I.R.C. § 267(c)(4) while use by aunts and uncles, nephews and nieces, in–laws, stepparents or domestic partners are not.
Hold Time Requirement
Revenue Procedure 2008-16 establishes a two year hold time as a safe harbor such that the IRS will not challenge the rental property character used for occasional personal use as 1031 eligible. Tax Court cases Goolsby v. Commissioner, TC Memo 2010-64 (April 1, 2010) and Reesink v. Commissioner, TC Memo 2012-118 (April 23, 2012) provide insight into cases with timeframes shorter than two years. The revenue procedure is not a must have, but to convert outside the safe harbor is at the taxpayer’s risk, see Moore v. C.I.R. T.C. Memo 2007-134 (May 30, 2007).
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