Moving into your 1031 property....

Have you ever thought of moving into one of your rental properties? Or perhaps buying something in a 1031 exchange that you could move into some day? If so, this Tee-Shot will explain the ramifications of doing this.
Tee-Shot from the 1031 Experts!

Using Section 1031 to Buy a House You Want to Live in
by Gary Gorman founding partner, 1031 Exchange Experts, LLC

The questions I get from clients seem to come in cycles – I won’t get any questions about a particular subject for a long time, then all of a sudden I’ll get the same question from different parts of the country. Such is the case with: can you buy a residence as your 1031 replacement property and then move into it?

Section 1031 rolls the taxable gain from the sale of your Old investment property over to your New. The key word here is investment. If you sell bare land and buy a rental house, Section 1031 rolls the gain on the land over to the house.

So what happens if you exchange land for a house and then want to move into it? You’re allowed to do this provided it is clear you bought the rental house for investment. If you move into it right away, you clearly did not buy it for investment; you bought the house to live in, and that does not qualify for 1031 treatment. To qualify the property as an investment you need to rent it, or seriously try to rent it, for at least a year and a day (unless the house is a vacation or second home in which case there are special rules that will extend the time frame to two years).

Let’s take a hypothetical situation and walk through the various tax rules that impact the transaction. Fred and Sue sell a piece of land in Minnesota in January of 2005, do a 1031 exchange and buy a house in Tucson, Arizona that they plan to retire into in a few years. They find a tenant who rents the house on a two year lease. Assuming they meet all the requirements for a 1031 exchange (which I’ve covered in the Realty Times article "Six Easy Steps to a 1031 Exchange" at: http://realtytimes.com/rtpages/20050815_exchangetips.htm ) they owe no tax on the sale of the land.

Two years later at the end of 2006, the tenant informs them he will not renew the lease and vacates the property. This coincides nicely with Fred and Sue’s retirement plans so they sell their Minnesota house and move into the Tucson house at the beginning of 2007. Although they have substantial appreciation on the Tucson house, does moving into it and converting it from an investment property to a personal residence trigger the gain? No, the gain is not triggered until they sell it.

So Fred and Sue live in the house for a couple of years (until the end of 2008 - so they’ve owned it for a total of four years), and they decide they would like to sell it and move to Hawaii. Is the gain taxable? Yes.

Because they bought the house as their rollover property in a 1031 exchange the law requires that they own it at least five years before they can take the $500,000 (because they are married) exclusion from the sale of a primary residence.

If Fred and Sue continue to live in the house until the end of 2009, they will have met the five year ownership requirement, as well as the requirement that the house be their primary residence for two of the five years before they sell it. After that, they can sell the house and take their $500,000 exclusion even though a substantial amount of the appreciation happened before they moved into it (while the property was 1031 property). Assuming the gain was less than $500,000, the only thing they would pay tax on would be the depreciation that they took on the house while it was a rental, which they are required to recapture.

What happens if Fred and Sue move to Hawaii at the end of 2008 and rent out the house during 2009, and then sell it? They still meet their five-year-ownership requirement, as well as the requirement that they occupy the house for two of the five years before they sell it, so they can take their $500,000 exclusion, but two additional rules kick in.

First, because the property was rental property the year before they sold it, they can choose between doing another 1031 exchange or taking their $500,000 exclusion. My advice: if you get the chance to take money off the table tax free – always take it! In other words, take the $500,000 exclusion and don’t do a 1031 exchange. Secondly, because the property was rental property in the early years before they moved into it there is a new law that will convert the post 2008 rental period into taxable gain.

You can read more about this new law in my Realty Times article titled, "Congress Limits Gain Exclusion on the Sale of Some Primary Residences."