A traditional 1031 exchange involves two properties used for business or investments. Read the specific rules printed by the IRS, and you’ll see sentences that specifically exclude personal residences from these types of transactions.
While there are tiny exceptions (which involve renting out the home you want to call your own for several years), most 1031 exchanges can’t involve selling a business property to buy a private home. This type of transaction just doesn’t fit the criteria. However, you can do a 1031 exchange on a personal residence or vacation home to trade it for a business property.
In this article, we’ll explain how a 1031 exchange on a primary residence typically works. Know that these are very technical transactions, and you’ll need an expert to help you make them work. If you miss even one required step, the transaction is not valid. Here’s what you need to know.
What Is a 1031 Exchange on a Primary Residence?
A 1031 exchange involves a complex transaction with two moving parts: a piece of property you sell and a piece of property you buy. In a workable 1031 exchange on a primary residence, the item you’re selling was your primary home for two out of the five prior years—and you can’t be living in it right now.
In an exchange, you’ll identify a second property that you’d like to purchase as a business or investment property. You’ll sell the primary residence, and you’ll roll your tax obligations into the second property. That obligation won’t be due unless you sell that second property and don’t roll those funds into another 1031 exchange.
Specific 1031 Exchange Rules on Primary Residences You Should Know
Imagine that you own a home and want to purchase a different property for business or investment purposes. These are the rules you need to know:
You Must Meet Ownership Requirements
To use a 1031 exchange, you must meet two very specific time frames. First, you must have owned the property for at least five years. Next, you must have lived in the property for two of those five years. That residency requirement doesn’t have to be continuous, so you could move in and out of the place as needed. But the time you spent living there must total 24 months.
You Can’t Use This Option Frequently
The rules specify that you can’t use a 1031 exchange process more than once in a two-year process. That means you can’t expand your portfolio multiple times with this tool (even though it’s understandable that you might want to do so).
You Meet a Residency Requirement
As we mentioned, you can only use this tool if you’ve owned the property for five years and lived in it for two years. This is a strict condition. If you don’t meet both of these requirements, you can’t use a 1031 exchange for this process.
You Can Prove You Used It for Profit
To use your primary residence in a 1031 exchange requires advanced planning. You must have plenty of paperwork that shows the IRS that you rented the property for an appropriate price. That means you can’t say you’ve rented out the property without the receipts to prove it. Ensure that you have all the paperwork you need (including rental agreements and bank statements) to prove you used the property to make money.
You May Have to Pay
Using a 1031 exchange is a way to save money, but it won’t completely wipe your debts away. The amount of gain you can exclude is $250,000. And you may not hit that limit.
The time you used the property as a residence may also be excluded in the exchange. For example, if you owned the property for five years and lived in it for two years, you can’t exclude depreciation during the time you were living in it. This paperwork and calculation are complex, and you may need help figuring it out. It’s worth it to hire an expert to guide you through the paperwork.
How Does the Exchange Work?
You’ve read through all the rules we’ve outlined, and you think you’re a good candidate for a 1031 exchange on a primary residence. How does this work?
Here are the steps involved in a typical 1031 exchange:
Hire an expert. You find a qualified intermediary to help you with the transaction. You can’t tackle this step yourself, and you can’t use someone like a friend. You must have someone with experience in these complex transactions to help you.
Sell the property. You place the home for sale, find a buyer, and place the proceeds in the control of your qualified intermediary.
Identify a new property. You create a signed document with specific details about the property you’ll buy as part of the exchange. You give this document to your qualified intermediary. You have 45 days from the sale to take this step.
Buy the new property. You complete the purchase of the property with the help of your qualified intermediary. You have 180 days from the sale of the original property to take this step.
Remember that you must use a qualified intermediary for this process. If you touch the money from the sale, the entire transaction could become taxable. There is flexibility on this step.
What Can I Use the Process to Buy?
Both properties in the transaction must be considered “like kind” by the IRS. The rules state that most types of real estate are considered like kind. You can trade an apartment complex for something like an office park.
However, remember that the item you buy must be used for commercial or business purposes. You can’t buy something you intend to live in as your primary residence.
Get Help With Your 1031 Exchange
We mentioned that you need a qualified intermediary to help you complete these transactions. At 1031 Pros, we’ve helped hundreds of people with complex 1031 processes. We can handle the funds and the paperwork, ensuring that everything moves forward as it should. Contact us to get started today.
References
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
26 U.S. Code 121: Exclusion of Gain from Sale of Principal Residence. Cornell Law School.
Sec. 121. Exclusion Of Gain From Sale Of Principal Residence. Bloomberg Tax.
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