Many people ask about the possibility of converting a 1031 replacement property into a principal residence. That’s our topic for this article.
If you later sell the hypothetical replacement property, now as your principal residence (IRC Section 121), you and your spouse may be able exclude up to $500K ($250 single), but the Section 121 principal residence exclusion applies only to the taxes on the appreciation in value, and will not exclude gains from the past deprecation (on the current property or the old property exchanged out of). So deprecation recapture will cause some tax inefficiency at the sale of the principal residence. Also, you have to wait five (5) years before to take a principal residence exclusion on a property that you 1031 exchanged into.
26 USC 121(d)(10) Property Acquired in a Like-Kind Exchange
If a taxpayer acquires property in an exchange with respect to which gain is not recognized (in whole or in part) to the taxpayer under subsection (a) or (b) of section 1031, subsection (a) shall not apply to the sale or exchange of such property by such taxpayer (or by any person whose basis in such property is determined, in whole or in part, by reference to the basis in the hands of such taxpayer) during the 5-year period beginning with the date of such acquisition.
The amount of the exclusion that you get to take also depends on the ratio of time that you used the property of rental (non-qualified use for 1031) and the period of time that you used the property as your principal residence (qualified for 121).
26 USC 121(b)(5)(B) Gain Allocated to Periods of Nonqualified Use
For purposes of subparagraph (A), gain shall be allocated to periods of nonqualified use based on the ratio which—
(I) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to
(ii) the period such property was owned by the taxpayer.
Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.
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