Turning 1031 Exchange Property into Your Personal Residence

When you sell your personal residence (the house you live in), the IRS says $500,000 of the gain ($250,000 if you’re single) is tax free. There are some things that you have to do to qualify for this benefit, the most important of which is that you must live in the house for at least two of the last five years.

There is a different code section, Section 1031, that says if you sell a house that’s been a rental for at least the last year (or two years in some situations), you can roll the gain from the old house to the new house and defer the tax on the gain until you sell the new house.

Sometimes these two IRS rules overlap. For example, when you sell your residence, it has to have been your residence for two of the last five years. Two of the last five… so what was happening during the other three years? Well, if you’ve lived in the house for all five years there’s no problem – just sell the property and $500,000/$250,000 of gain is forgiven.

But if you’ve rented the house during the other three years, especially if one of those years is the year before you sell it, you could do a 1031 exchange and roll the gain over to another investment property and defer the tax. However, you should consider this option carefully as you might be turning tax-free, never-to-be-taxed-again gain from the sale of a residence into a 1031 gain that WILL be taxed someday. Given the choice, ALWAYS, take the tax free option.

An exception to the rule that $500,000/$250,000 of the gain is tax free involves a residence that was purchased with 1031 exchange proceeds. The IRS has special rules for taxpayers who buy a rental property as their 1031 replacement property and later move into it. For example, if you sold a rental property in Kansas, did a 1031 exchange and bought a property in Vail, Colorado, rented it out for several years, and then moved into it as your primary residence for a couple of years, your excluded gain when you sell the Vail house could include some of the gain that was rolled into it from your exchange.

Given the choice, ALWAYS, take the tax free option.

The IRS penalizes you for time that your property is not your primary residence; you have to prorate the gain between the periods the property was your primary residence, and the periods that it was not. (Your primary residence is the place you live; the address you use on your driver’s license; where you're registered to vote, etc.)

Only the non-residence period after January 1, 2009 is excluded. So if you bought or exchanged into a property on January 1, 2007, rented it for three years, moved into it on December 31, 2009, then lived in it for 3 years until you sold it, you would have owned the property for 6 years, during which it was a rental for 3 and your residence for 3. However, since only one of the rental years was after January 1, 2009, the numerator in your calculation would be one (the number of rental or non-residence years after January 1, 2009), and your denominator would be 6 (the total number of years you owned the property). In other words, 1/6 of your gain would be taxable; if your total gain was $300,000, then $50,000 of that would be taxable, even though you would otherwise be entitled to an exclusion of $500,000.

I use the term non-residence period rather than rental period because it's not necessary that you actually rent the property – the law deals with the periods that the property is your residence, versus the periods that it is not. In my example above, if the Vail property had been vacant instead of a rental for the three years before you moved into it, and then your residence for the next three years, the result would have been exactly the same: $50,000 of the gain would be taxable out of a total gain of $300,000. Ditto if one of your relatives lived in the house rent free instead of the house being vacant.

The law only covers those situations when the property was not your residence before it became your primary residence. It does not cover situations where it was your residence first, and then became vacant or a rental property. This is so that homeowners who are forced to rent their former residence while they try to sell it would not be penalized.