If you own multiple residences, you might one day consider moving from one to another. As you get closer to retirement, downsizing in your current city could be an option, or perhaps you’re thinking of moving now to the city in which your favorite rental property is located. We are frequently asked how to convert a 1031 exchange rental property to a primary residence, and we have guided many of our clients through the process.
Consider IRC 121 When Converting Your Rental Property
The key to a successful conversion from rental property to primary residence is timing. The IRS has provided a safe harbor rule for converting a rental property in this manner. In order not to invalidate the 1031 exchange, the rental property must be held for 24 months and, in each 12-month period, the property must be rented out at market rate for no less than 14 days. As the owner, you can use the property for personal purposes for no more than 14 days or 10% of the total number of days it was rented.
If you are unable to meet the safe harbor requirements, there are rightful steps you can take to pass IRS scrutiny. For example, advertise the property and be prepared to justify the rent amount. Also, do not make changes to the property to customize it for your personal use while it is still a rental. If life changes (a new job, marriage, divorce, etc.) force you to move, be sure to keep all related documents, in case the IRS asks you to support your claim.
By law, you can only have one primary residence. So when you decide to sell that residence or replace it with a rental property you want to convert to your primary residence, it’s important to consider IRC 121. IRC 121 gives homeowners a capital gains tax exclusion on the sale of their primary residence of up to $250,000 for a single owner and $500,000 for a married couple filing jointly. The 121 exclusion only applies to a primary residence you have held for at least five years and lived in for at least two of those years.
The capital gains exclusion is only available for the time a property is your primary residence. This is referred to as qualified use. There is no non-qualified use before the beginning of 2009, when this rule came into being, although years before 2009 are included in calculations of ownership time. No recapture of depreciation taken after May 6, 1997, is eligible for the 121 exclusion.
Thus, if you acquired a rental property through a 1031 exchange in 2002, made the property your primary residence in 2012, and sold it in 2017, you would be eligible for the 121 exclusion and three of the 15 years you owned the property would have non-qualified use (2009-2011). Therefore, 20% (3/15) of your capital gains would be taxable (not eligible for the IRC 121 exclusion).
Selling Your Former Primary Residence
The distinction between qualified and non-qualified use no longer applies after you move out of your primary residence. You can sell the property within five years, and the time leading up to the sale will count as qualified. Thus, if you move and are unable to sell the property you move from, or choose not to sell it, that will not immediately affect the 121 capital gains exclusion.
If, for instance, you moved out of the property in 2012 and wanted to wait to sell or exchange it, you could wait until 2015 to sell without losing a portion of your 121 exclusion, since you had lived in it for two of the last five years. The property could be rented out between 2012 and 2015, or used in other ways (a relative could live there rent-free, for example). However, in 2016, you would no longer be qualified for the 121 exclusion at all, since you would not have lived in the home for two of the last five years.
Strategic Considerations When Converting a Rental Property
When planning a sale related to converting a rental property to your primary residence, keep in mind that capital gains are cumulative over the time you own your property. You can minimize potential capital gains taxes by converting a rental property that has appreciated greatly during your ownership, thus making it eligible for the 121 exclusion at the eventual time of its sale or exchange.
Sale of your rental property into your primary residence can be complicated when the distinction between residence and investment property is narrow. The sale of a small multifamily dwelling (four units or fewer) in which one unit is owner-occupied is an example of a case when particular care needs to be taken; the sale of a farm is another.
Given that the tax losses from a conversion of any rental property to a primary residence could be high if the proper steps are not taken, it is advisable to move forward only with expert guidance.
At CWS Capital Partners, we have decades of experience guiding investors through 1031 exchange transactions. Contact us today to learn more and to get started.
The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
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