Recently, a client of mine asked me whether it was possible to take advantage of the Section 1031 tax-deferred exchange by taking the sales proceeds from his commercial building and acquiring a single-family residential property for rental purposes, and then claim the Section 121 $250,000 exclusion from gain on the sale of a primary residence by moving into the property and subsequently selling it. He was worried that he would be prevented from using these tax benefits because of the structure of his transaction. Here’s what I told him:
As an initial matter, there’s no need to worry about the fact that the rental house is too dissimilar to the commercial building to qualify for tax-deferred treatment under Section 1031. This section allows, with few exclusions, for the deferral of gain in exchanges of property of “like-kind which is to be held either for productive use in a trade or business or for investment.” In addition, the Internal Revenue Service has stated that most real estate will be like kind to other real estate and that quality or grade does not matter; for example, real estate on which a rental house is located is like-kind to vacant land.
There are, however, rigorous restrictions on how this rental property will be used after it has been acquired in order to qualify for 1031 tax deferral. Because this rental property must be held for use in a trade or business or for investment to qualify for tax deferral, the IRS has established a “safe harbor” rule that imposes a two (2) year holding period as a rental property to avoid IRS challenges. Each year during this period, the owner must rent out the property at a fair rental for at least fourteen (14) days, and must also not engage in personal use of the property for the greater of (a) fourteen (14) days or (b) ten percent (10%) of the number of days the property is rented out. Once this safe harbor has been met, the rental property will qualify as replacement property under Section 1031.
Further, once the owner has qualified for this safe harbor and Section 1031 tax deferral has been achieved, there are additional constraints imposed when this rental property is converted into a personal residence in order for the owner to take advantage of the Section 121 $250,000 exclusion of gain. The main limitation is that the taxpayer may not claim this exclusion during the first five (5) years after acquiring the property through the Section 1031 exchange. After this period has expired, the owner’s residence in the property must otherwise qualify for the exclusion at the time of sale, i.e., the owner must have resided in the home for at least two (2) of the previous five (5) years prior to the sale in order to claim the exclusion.
Once these qualifications have been met, however, there are additional limitations on the exclusion/deferral of gain in this scenario. First, for property that was acquired in a Section1031 exchange, for purposes of the Section 121 exclusion, any period of time in which the property was not used as the owner’s personal residence is treated as “non-qualified use,” for which the exclusion will be reduced on a pro rata basis. For example, for rental property acquired in a 1031 exchange, if the owner rents out the property for two (2) years, occupies it as his personal residence for three (3) years, and then sells it after the end of the five (5) year restricted period, the owner would be able to claim 3/5 of the Section 121 $250,000 exclusion, or $150,000. Finally, recaptured depreciation is not eligible for the exclusion and is subject to tax.
It is also critically important that the owner avoid giving any premature indication of any intention other than to hold the property for trade or investment, or to ultimately use the property as a personal residence, at the risk of losing the Section 1031 tax deferral. Given the complexities of these restrictions, real estate investors contemplating these sorts of transactions would be well-advised to seek the advice and assistance of experienced attorneys, accountants, brokers, and exchange professionals before embarking on this type of transaction.