Have Your Cake and Eat It Too: Converting 1031 Property into Your Personal Residence

Suppose several years ago you did a 1031 exchange and bought a charming rental property in a nice urban area as your replacement property. Now you’re planning retirement and are considering downsizing, making your rental property your residence. Will the IRS let you? If so, are there strings attached?

...Now you’re considering downsizing. Will the IRS let you? If so, are there strings attached...?

Section 1031 allows you, subject to certain rules, to sell an investment property and roll the gain over to a replacement investment property. The new property must be an investment property, so no – you couldn’t sell your rental and buy a different house that would be more comfortable for you to immediately move into.

But if the rental would be comfortable for you to live in, could you move in right away? The law says that your 1031 replacement property must be held as an investment property for at least two years. So if you’ve owned the rental for at least that long, then yes, you may now sell your primary residence and move into the rental without immediate tax consequences.

Because the rental was a 1031 exchange replacement property before you moved into it, there are a couple of considerations you must remember: First, to get a pro-rated gain exclusion on the sale of a primary residence (more on that in a minute), you must own the rental for at least five years before you sell it.

Second, your gain from the sale of the property you sold when you bought the rental rolled over to it and reduced your tax basis in it. It would be taxed when you sell it. For example, if your gain on your first property was $200,000 and you bought the rental for $350,000, then your <i>tax basis</i> on the rental is $150,000 less any additional depreciation taken during the years it was a rental property. This means that if you sell the rental for $600,000 your taxable gain <i>might</i> be $450,000. Plus, you would have to recapture the depreciation you took on the rental while you owned it.

I say “might” because if you sell your residence (your home - where you and your cats and dogs live), and if you’ve lived in your residence for at least two years, you can sell it and up to $250,000 ($500,000 if you’re married) of the gain is tax free. This law would certainly apply to your home if you sell it and move into the rental, but what about when you sell the rental after you’ve lived in it?

Remember, as I said above, if you end up living in a property that you originally bought for a 1031 exchange, you have to own the property for at least five years, and at least two of those years it has to be your personal residence.

So in summary, if you owned the rental for at least five years, and if it was your primary personal residence for at least two of those years, then with the exception of some depreciation recapture, a portion of the gain will be tax free. The $250,000 ($500,000 if you are married) gain exclusion is reduced by a ratio of the time the property was used as a primary residence compared to the time the property was used as a rental investment.