1031 Exchange: Turn Your Home Into a Tax-Deferred Asset

  • Real estate
  • 1/21/2025
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Converting a home into a 1031 exchange property can help defer capital gains taxes. Learn essential steps to enhancing investment potential.

Converting a principal residence into a qualified property for a 1031 exchange transaction can be a strategic move for homeowners looking to defer capital gains taxes. This process involves several steps and considerations to maintain compliance with IRS regulations. 

In this blog, we explore key steps in converting a principal residence to a qualified property for a 1031 exchange with the possibility of still using the principal residence sale exclusion.

Understanding 1031 exchange transactions

A 1031 exchange, also known as a like-kind exchange, allows taxpayers to defer paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into a similar property. To qualify for a tax-deferred 1031 exchange, the property must be held for investment or used in a trade or business and cannot be a current principal residence.

Converting a principal residence so it qualifies

To convert a principal residence into a property that qualifies for a 1031 exchange, the homeowner must abandon the personal use of the property and hold it for rental income or appreciation in value.

There is a safe harbor approach found in Rev Proc. 2008-16 that states the property must be rented to another person at a fair rental value for at least 14 days in each of the two 12-month periods immediately before the exchange to qualify for 1031 exchange treatment.

Additionally, the homeowner's personal use of the property cannot exceed the greater of 14 days or 10% of the number of days the property is rented at a fair rental value.

Exclusion of gain under IRC Section 121

Homeowners can also exclude up to $250,000 ($500,000 for married couples filing jointly) of gain on the sale of their principal residence under IRC Section 121, provided they have owned and used the property as their principal residence for at least two years within the five-year period ending on the date of sale.

If the property has been converted to a qualified property, the homeowner can still exclude the gain under Section 121 and defer the remaining gain under Section 1031 if the abandonment of principal residence status is timed strategically.

Example scenario

Consider a single homeowner who has used their house as a principal residence from 2018 to 2022 and then converted it to a rental from 2022 to 2024. If the homeowner sells the house in 2024 for $500,000, with an adjusted basis of $200,000 and a realized gain of $300,000, they can exclude $250,000 of the gain under Section 121 and defer the remaining $50,000 under Section 1031. This scenario illustrates how homeowners can benefit from both the gain exclusion under IRC Section 121 and tax deferral provisions under IRC Section 1031.

Potential pitfalls to avoid

While converting a principal residence to a qualified property for a 1031 exchange can offer significant tax benefits, there are potential pitfalls to avoid:

Non-qualified use

Be aware that any period the property is not used as the taxpayer's principal residence is considered non-qualified use. Non-qualified use can affect the exclusion of gain under IRC Section 121.

Fair rental value

The property must be rented at a fair rental value, especially if renting to a family member — in which case the property must also be rented for use as that family member's principal residence. Otherwise, the rental is treated as personal use by the taxpayer. Renting at below-market rates can raise red flags with the IRS and potentially disqualify the property from a 1031 exchange.

Documentation and recordkeeping

Maintain thorough documentation and records of rental periods, rental income, and personal use of the property. Proper documentation is essential to substantiate the property's qualification for a 1031 exchange in case of an IRS audit.

How we can help

Converting a principal residence to a qualified property for a 1031 exchange transaction requires careful planning and adherence to complex IRS guidelines. By understanding the requirements, leveraging the safe harbor provisions, and avoiding potential pitfalls, homeowners can effectively defer capital gains taxes while enhancing their investment potential.

CLA has qualified tax professionals who specialize in 1031 exchange transactions and consulting and can advise you from start to finish if you are looking to sell your principal residence and defer capital gains on the sale.

This blog contains general information and does not constitute the rendering of legal, accounting, investment, tax, or other professional services. Consult with your advisors regarding the applicability of this content to your specific circumstances.

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