Let's say that you do a 1031 exchange - you sell an investment or business property and you buy a property that is a single family rental and you rent that property out for a number of years to substantiate the property for investment or business purposes to qualify it for 1031.
Well after you’ve held the property for a substantial period of time it may occur to you that you could see yourself living in it as your principal residence.
So sometimes folks will kick the tenants out of that investment or business property and move into it as their principal residence. Timing and intention are important factors to consider in this scenario.
Timing & Intention
First you probably want to wait a year or two before you kick the tenants out so that you satisfy the requirements of 1031 that you were actually holding the property for investment or business purposes.
Section 121 Exclusion
Then after you kick the tenant out you can move into the property and make it your personal residence. Now there's an interesting interplay between section 121 of the Internal Revenue Code and section 1031 that says you must wait 5 years after completing the exchange before you can avail yourself of the section 121 principal residence exclusion on the sale of your principal residence.
Furthermore you don't get the entire exclusion, you get a fraction of it based on the qualifying used as your personal residence as a ratio against the time that it was used for rental purposes.
So theoretically if you rented the property for 2 years and you lived in it as your personal residence for 3 years you would be entitled to three fifths of the exclusion. For married couples the exclusion is normally $500,000, but in this situation you would be entitled to three fifths of that or $300,000 which is pretty good exclusion amount.
Depreciation
One consideration is that under section 121 you're not allowed to exclude the depreciation. So to some degree it's a partial victory because you still have to deal with the un-recaptured depreciation that may have carried over into the property and also the depreciation on the current principal residence.
Nevertheless this is an awesome tax planning technique and if you look at the interplay between section 121 and 1031, this is a rather frequently used combo of piggybacking the 1031 exchange with the 121 exclusion and putting them together after 5 years.
Start Your Exchange : If you have questions about the interplay between section 1031 and the 121 exclusion, feel free to call me at 612-643-1031.
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