Section 1031 and Your Primary Residence: What You Need to Know

Today, many people have a significant amount of equity in their homes. The median sale price of houses sold in the United States has risen by approximately 31 percent over the past five years, and it has nearly doubled since 2010. Of course, if you stand to turn a substantial profit from selling your home, you could be facing a substantial tax bill as well—and, as a result, you may have questions about working with a 1031 exchange company.

So, what do you need to know?

Unfortunately, as a general rule, it is not possible to use a 1031 exchange to indefinitely defer tax liability on the sale of your primary residence. This is made clear by the language of Section 1031 itself, which states: “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind . . . .” If a piece of real property is your primary residence, it is not “held for productive use in a trade or business;” and, even if it has increased in value significantly, it also is not held “for investment” for purposes of Section 1031.

Taking Advantage of the Home Sale Tax Exclusion

It is important to note, however, that even though selling your primary residence does not provide an opportunity to take advantage of Section 1031, it may provide an opportunity to take advantage of the federal home sale tax exclusion. As the Internal Revenue Service (IRS) explains:

“If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse.”

The home sale tax exclusion exists under Section 121 of the Internal Revenue Code (IRC); and, unlike Section 1031, Section 121 provides a true exclusion—not a deferral. While Section 1031 allows taxpayers to indefinitely defer capital gains tax liability on a like-kind exchange (when it applies), Section 121 allows taxpayers to exclude qualifying gain from the sale of their primary residence without the potential for future tax liability.

As the IRS also explains, “to qualify for the Section 121 exclusion, you must meet both the ownership test and the use test.” If you’ve lived in your home for at least the last two years, you will generally satisfy both of these tests. Other scenarios can get more complicated, and if you have questions, you should seek professional advice before claiming a substantial tax exclusion on the sale of your home.

Converting Your Primary Residence Into an Investment Property

If the home sale tax exclusion will not allow you to avoid a federal tax bill when you sell your home, you may still be able to take advantage of Section 1031 by converting your primary residence into an investment property. Among other things, this will require:

• Moving out of your home, and,
• Renting your home for at least 14 days during each of the two years after you move out.

To qualify for a 1031 exchange, you may not live in the home for more than 14 days or 10 percent of the days it is rented in each of the two years prior to the exchange. You must rent the home at fair market value.

It is also important to keep in mind the “exchange” aspect of securing indefinite tax deferral under Section 1031. If you convert your primary residence into an investment property, when you sell it, you must purchase another investment property to replace it. You could eventually transition this into your primary residence, but you must use the property as a rental (according to the same terms listed above) for at least the first two years of ownership.

In short, if you are thinking about converting your primary residence into an investment property for purposes of conducting a 1031 exchange, there is a lot to consider. We can help you make an informed decision, and if you’d like help, we encourage you to contact our 1031 exchange company for more information.

Contact 1031 National Services | A 1031 Exchange Company

Do you have questions about converting your primary residence into an investment property so that you can conduct a 1031 exchange? If so, we invite you to get in touch. To request a free consultation at 1031 National Services, a 1031 exchange company, please call 888-872-1031 or contact us online today.