When Can I Move Into a 1031 Exchange Property?
Learn how to properly convert a 1031 exchange property into a primary residence, including the key requirements for timing and use to protect your investment.
A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting sale proceeds into a new, “like-kind” property. A common question is when an investor can move into a residential property acquired through such an exchange. While converting a 1031 property into a primary residence is permissible, it is governed by specific Internal Revenue Service (IRS) regulations, and the process requires the owner to first prove the property was acquired for investment purposes to protect the transaction’s tax-deferred status.
The Foundational Investment Intent Requirement
The principle of a 1031 exchange, outlined in Section 1031 of the Internal Revenue Code, is that the property must be “held for productive use in a trade or business or for investment.” This means your primary motivation when acquiring the replacement property must be for investment, not personal use. The IRS assesses this intent based on your actions immediately following the purchase.
To substantiate investment intent, you should treat the property as a business asset. This involves actively marketing it for rent at a fair market rate and securing a tenant with a formal lease agreement. Maintaining meticulous records, such as a separate bank account for rental income and expenses, also demonstrates a professional approach to ownership.
Conversely, actions that suggest personal use can jeopardize the exchange. These include moving personal belongings into the home, performing renovations for personal taste, or leaving the property vacant without trying to rent it. If the IRS determines the property was acquired for immediate personal use, it can disqualify the exchange, making the original capital gains immediately taxable.
Safe Harbor Rules for Converting to Personal Use
The law does not specify an exact holding timeframe, but the IRS provides guidance in Revenue Procedure 2008-16. This establishes a “safe harbor,” meaning if you meet its criteria, the IRS will not challenge your property’s investment status. This provides a roadmap for investors who plan to eventually convert their 1031 property into a primary residence.
The safe harbor requires a minimum holding period of 24 months after acquisition. Within this two-year window, specific rental and personal use tests must be met for each of the two 12-month periods.
In each of the two 12-month periods, the property must be rented at a fair market rate for at least 14 days. Your personal use of the dwelling during each 12-month period cannot exceed the greater of 14 days or 10% of the total days it was rented at fair market value. For example, if you rented the property for 300 days in a year, your personal use could not exceed 30 days. Meeting these thresholds for two consecutive years satisfies the safe harbor.
Tax Consequences on a Future Sale
After converting the 1031 property to your primary residence, different tax rules apply to a future sale. The main benefit is the Section 121 exclusion, which allows a homeowner to exclude capital gains from taxation. An individual filer can exclude up to $250,000 of gain, while married couples filing jointly can exclude up to $500,000.
To qualify for the Section 121 exclusion, you must meet ownership and use tests. The ownership test requires you to have owned the property for at least two of the five years before the sale. The use test requires you to have lived in it as your main home for at least two of those same five years. For a property acquired via a 1031 exchange, you must own it for a total of at least five years before using the exclusion.
The Section 121 exclusion must be prorated for 1031 properties. The exclusion does not apply to gains from periods of “non-qualified use” after December 31, 2008. Non-qualified use is any period the property was not your principal residence, such as when it was a rental. The portion of the gain ineligible for the exclusion is calculated by creating a ratio of the non-qualified use period to the total ownership period.
For example, a married couple acquires a property in a 1031 exchange. They rent it for three years and then live in it as their primary residence for three years before selling. They have owned the property for six years and have a capital gain of $600,000. Since the property was a rental for three of the six years, 50% of the gain ($300,000) is from non-qualified use and is taxed as a capital gain. The remaining $300,000 is eligible for the Section 121 exclusion and would be excluded from taxes, as it is below their $500,000 limit.