Converting a 1031 Exchange Property into a Primary Residence

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You can eventually convert an investment property that you acquired through a 1031 exchange into your primary residence.

 

What is a 1031 Exchange?

 

When you sell a business or investment property and you have a profit or gain, you usually pay capital gains taxes on your profit at the time of the sale. Section 1031 of the U.S. Internal Revenue Code allows you to postpone paying those taxes if you invest the proceeds from the sale in a similar or like-kind business or investment property. This is referred to as the replacement property. When you sell the replacement property outside of another exchange, your original deferred gain, plus any additional gain from the sale of the replacement property, is subject to taxation.

 

Does My Home Qualify as a 1031 Exchange Property?

 

The exchange of personal residences, whether a primary home or a vacation home, does not qualify as a like-kind exchange of investment property, even if the residences are expected to increase in value and can therefore be viewed as investments. However the exchange of vacant land for real property that has been improved with a rental home qualifies as a 1031 like-kind exchange, as long as both properties are located in the United States. Your adjusted basis in the property you relinquish in a 1031 exchange is transferred to your replacement property. This preserves your deferred gain for tax purposes.

 

How Do I Convert My Replacement Property into My Primary Residence?

 

The holding requirements of Section 1031 must be satisfied before the primary use of your replacement property is changed. The Internal Revenue Service (IRS) does not have specific holding requirements. However it is generally suggested that replacement property should be held in its original intended use for at least one year before converting it to another use. For example, if you acquired your replacement property as an investment property in a 1031 exchange for another investment, it should be retained as an investment property for at least one year.

 

According to the IRS, a dwelling unit that is a replacement property in a 1031 exchange must be held either for productive use in a trade or business or for investment. Your replacement property qualifies if each of the following conditions is satisfied:

 

  • You owned the dwelling unit for at least 24 months immediately following the exchange. This is called the “qualifying use period.”
  • Within each of the two 12-month periods within the qualifying use period, you rented the dwelling unit to another person for a fair market price for 14 days or more.
  • Within each of the 12-month periods that the dwelling was rented at a fair market price, your personal use of the dwelling did not exceed 14 days or 10% of the number of days it was rented, whichever is greater.

 

The first 12-month period begins on the day after the exchange and the second 12-month period begins on the day after the first period ends.

 
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