Can You Use a 1031 Exchange for Primary Residences?

1031 exchanges can help real estate investors avoid paying capital gains taxes when they sell properties. Depending on your situation and the value of the home, these exchanges can save you thousands come Tax Day. For many investors, this leads them to wonder if they can perform a 1031 exchange for primary residences.

Unfortunately, you can only use 1031 exchanges for investment properties. But there is an exception that you may want to be aware of. Here’s what you need to know.

The IRS Prohibits 1031 Exchanges on Primary Residences

Under IRC section 1031, exchanges can only be used on like-kind investment properties. They cannot be used for primary residences. This is because the IRS requires all properties exchanged under Section 1031 to be used for business or investment purposes. If the property is used as a primary residence or vacation home, it likely won’t qualify for an exchange. However, there is an exception to the rule.

If you convert your primary residence to a rental property and avoid living in it for a sufficient length of time, you may be able to exchange the property for a like-kind property in the future.

This means you’ll have to hold onto the property for ideally a few years and won’t be able to use the proceeds of the sale of the property to purchase a new primary residence. However, you may be able to use the money you earn from the rental property to boost your down payment or help cover the cost of a new mortgage and maintenance on your new primary residence.

How to Use a 1031 Exchange on a Primary Residence

Though it’s possible to use a 1031 exchange on a primary residence that you convert into an investment property, the process is a bit more involved than you might think. Here are the steps you’ll need to take to ensure that your property is eligible for a 1031 exchange.

1. Move Out of Your Home

Before you can initiate your exchange, you need to convert your primary residence into an investment property. This starts with you and your family moving out of the property.

By moving out, you’re signaling that the property is no longer your primary residence. During this time, you’re free to buy another home or rent a home depending on your needs and your budget.

2. Rent Out the Property

Once you’ve moved out, you’ll need to transition the property into an investment property. In most cases, this involves renting the home to qualified tenants. You’re free to set your own requirements and choose tenants whom you’re comfortable renting to. This can be a friend, family member, or a complete stranger. It’s up to you.

However, you should collect rent on the property for it to qualify. The rate must be fair, meaning it should be roughly in line with the market. If you set the rate too low because you’re renting to a friend or family member, the property may not qualify as an investment property.

3. Maintain the Property as a Rental for a Sufficient Time Period

The IRS doesn’t specify how long you must keep your property as a rental for it to be eligible for a 1031 exchange. Instead, it’s recommended that you maintain the property as a rental for sufficient time to show you intend to use it for investment or business purposes. Some tax practitioners recommend that you own the rental for at least two years based on the facts in one non-binding IRS private letter ruling.

You’re not required to keep the property rented for that full ownership period, but it should be listed as a rental even if your tenants have moved out. And ideally, the property should be rented for at least 14 days each year. Remember, you can use this to your advantage. By renting the property out, you’ll be able to collect rent and put the property to work, potentially increasing your bottom line.

It’s important to note that you shouldn’t move back into the home if the property is not occupied. Moving back in could signal that you’re no longer using the home for business purposes and may disqualify it from a 1031 exchange.

4. Keep Detailed Records

Treat your rental property as a business, even if it’s the only one you own at the time. Keep detailed records for all activity and costs including mortgage payments, taxes, maintenance, property management, and other similar expenses. The more detailed your records are, the easier it is to prove that the property isn’t your primary residence.

5. Conduct Your 1031 Exchange

Once you’ve firmly established your former residence as an investment property and have rented out the property or made it available to rent for a few years, you should be able to conduct a 1031 exchange on the property.

The Benefits of Using a 1031 Exchange for a Former Primary Residence

Using a 1031 exchange for a former primary residence offers several benefits. This includes but is not limited to the following:

Diversification: By turning your primary residence into an investment property, you’re able to build a more diverse investment portfolio.
Added income: Renting out your former home can give you a reliable source of income that may last for years. You’re free to use that income however you see fit, including purchasing additional investment properties to further increase your portfolio.
Tax benefits: When you meet the 1031 exchange qualifications, you’ll be able to sell your former residence and purchase a new investment property without having to pay capital gains taxes on the sale. This may save you thousands of dollars during tax season. It also allows you to invest a larger amount of equity in the new property.

Keep in mind that the benefits you’ll see will largely depend on your situation.

How to Decide if a 1031 Exchange for a Personal Residence Is Right for You

Ultimately, deciding to pursue a 1031 exchange on a personal property, like your primary residence, is a matter of personal preference. It takes effort and time, and you may not immediately see the gains you’re hoping for. But there are a few questions you’ll want to ask yourself before you pursue this option:

Can you afford to move? If you’re unsure whether you can afford to buy a new home without selling your current one or aren’t confident that you can afford rent and your mortgage payment at the same time, selling your existing home may be a better choice. But if you can afford it, turning your primary residence into an investment property may be beneficial down the line.
Can you wait to sell the property? Your primary residence must be an investment property for a sufficient length of time to qualify for a 1031 exchange. This means you won’t be able to sell your home immediately. Make sure you’re comfortable waiting for roughly two years to sell the property. If you need the cash from the sale sooner, you may be better off just selling your home.
Are you willing to take on the responsibilities of a landlord? Renting a home to tenants takes a lot of effort and time. Make sure you’re willing to assume those responsibilities and potential extra costs before you commit to turning your primary residence into an investment property.

If you’re confident that you can afford to wait to sell your property and you’re willing to rent your home out to tenants, pursuing a 1031 exchange may be in your best interest. But if anything doesn’t feel right or you need the money from the sale of your home to purchase another, you may be better off paying the capital gains tax on the sale.

Ready to Tackle a 1031 Exchange on a Primary Residence?

If you believe that turning your primary residence into an investment property could help your financial situation in the long run, taking advantage of a 1031 exchange when you sell your former residence could help you reduce your tax liability and make it easier to invest in a new property.

Not sure if a 1031 exchange is the right move for your situation? Ask an expert and get the answers you need today.