A 1031 exchange is designed for investments. Typically, people use this tool to sell one investment property (like an office building) to purchase another (like an apartment complex) while avoiding immediate capital gains tax.
Per these rules, you can’t move immediately into a property you purchase via a 1031 exchange. However, there are loopholes and techniques you can use to purchase the primary home of your dreams via an exchange.
What Is a 1031 Exchange?
Capital gains taxes apply when you sell a property and make a profit. A 1031 exchange allows you to wrap those tax obligations into the new property.
As the IRS explains, a 1031 exchange is a linked transaction of two properties. An investor sells one property and places the funds in trust with a qualified intermediary. Then, the investor identifies a second property and asks the qualified intermediary to release funds for the sale. At that point, the tax obligation is rolled into the new property.
A 1031 exchange is not a simple sale of one property and the purchase of another. Instead, this is a coordinated approach that transfers one investment into another. And the word “investment” is key here. People should use these deals only to improve their portfolios and help their profits grow. They are not designed for things like buying a primary residence or flipping a property for a quick profit.
What Properties Qualify for a 1031 Exchange?
The IRS has rules about the types of properties that can be used in a like-kind exchange. For example, the rules state that the two properties must be “like-kind” to qualify. While all real property is like-kind, an important distinction exists.
Two properties are like-kind if they are both used for investment purposes. If you’re selling an investment property to purchase a primary residence, you’re violating the rule immediately.
Some exceptions exist. For example, you can use a 1031 exchange on vacation homes. With this approach, you could diversify your portfolio and upgrade to a more desirable property. You could also stay in the vacation home for (very) short periods without breaking the rules.
However, a primary residence is a little different. There are ways to make this approach work, but you’ll need both time and patience to ensure you do it correctly.
Can You Live in a 1031 Exchange Property Immediately?
Unfortunately, you can’t close on a new property via a 1031 exchange and then move into the place immediately and make it your home. Doing so would break IRS rules and could come with steep tax consequences.
Remember that the IRS rules specify that you’re not required to recognize gain or loss on property held for use in trade or business. If you move into a space as your primary residence, it’s no longer being held for trade or business. Instead, it’s just your home.
This doesn’t mean you can’t ever make a property you love your primary residence. However, it does mean that you need to wait at least a little while and ensure that you can prove that you’re using it for business during that time. Careful planning is important.
When Can You Live in a 1031 Exchange Property?
A 1031 exchange holding period can help you ensure that you hang onto a property for long enough that the IRS feels comfortable that you actually bought something as an investment. While no specific rule exists that applies to every situation, IRS documents suggest that two years is typically sufficient. In other words, you must wait at least 24 months between buying the residence and considering it your primary home.
During your waiting period, keep accurate records that prove you made money on the property. Rental records, check stubs, and other paperwork prove that you both bought an investment property and made it work for you.
How to Convert an Investment to a Residence
We’ve mentioned that you must wait at least two years before making a property you purchased via an exchange your primary home. However, there are things you can do during this waiting period to make the conversion a little easier.
For example, you could live in the residence for less than 10% of the number of days the home is rented. For example, you know that someone is moving out, and you could move in yourself for a week or two. These trial periods can help you ensure that the property is truly right for you.
When the waiting period has passed, you can move into the property and convert it into your primary residence. The paperwork you must do depends on whether the property is held by you as an individual or by your business. Make sure that you take this step properly to ensure the home is registered in your name and is your residence.
Risks of Conversions You Should Know About
Using a 1031 exchange is a smart way to purchase your dream home while avoiding taxes caused by capital gains. While this method works, it does come with a few risks.
For example, some people assume that a 1031 exchange wipes away their tax obligation altogether. However, that’s a myth. The taxes you owe are rolled into the property you bought. In some cases, conversions involve a sale. In those cases, the taxes you rolled forward come due.
Another risk involves the temptation to move in too quickly. Some people worry that renting out their potential dream home could lead to damage, so they just let the property languish. This isn’t smart. Remember that the IRS expects you to prove that you’ve actually made money on the property. You must rent it out and make money on it, even if it worries you to do so.
The final risk involves being disappointed with the property. If you convert it to your primary residence and change your mind, you’ll have to follow the same process and convert it back to a business property.
Why Should You Convert?
A 1031 exchange allows you to sell property and buy something new without paying capital gains on the profits. The money you save by not paying taxes could help you to fund the purchase of a property you could never avoid in any other way.
A conversion process also allows you to make money on the property for a few years. By renting it for a few years, you can also make the property easier to afford as your primary residence.
A conversion also allows you to watch a property’s value for a few years. If you’re worried about buying a primary residence and losing your money in time, by purchasing it and renting it, you can watch the market and ensure that this is a good home for you and your future.
Get Help with These Transactions
A 1031 exchange comes with plenty of benefits, but you’ll need help to make the process run smoothly. At 1031 Pros, we only handle these types of deals. We’ve helped thousands of investors complete processes like these, and we have the tools and methods to make them work as they should. If you need help, we’re here for you. Contact us to get started on your investment plan today.
References
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
Like-Kind Exchanges: Real Estate Tax Tips. (August 2024). Internal Revenue Service.
Info 2009-0060. (October 2008). Internal Revenue Service.
Private Letter Ruling 8429029. (1984). Bradford Tax Institute.
Like-Kind Exchanges of Real Property: New Final Regs. (April 2021). The Tax Adviser.
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