Converting Rental Property into Your Primary Residence
In real estate, swapping an investment property for another defers any capital gains tax on the sale. What is even more exciting is that you are not limited to executing a swap involving the same properties to take advantage of this tax break. In the eyes of the Internal Revenue Service, like-kind exchanges can refer to any piece of real estate not meant for personal use.
Of course, you need to seek reliable 1031 exchange services to structure the deal correctly. Otherwise, the IRS may go after you.
Although a 1031 exchange explicitly says investment properties must be part of the transaction, it is possible to turn your replacement piece of real estate into your new home or principal residence down the road without getting hounded by tax collectors.
If you want to swap a like-kind asset for a vacation house, a condo, or a townhome for personal use, below are the things you should do to keep the exchange tax-deferred.
Rent It Out for Two Years
One of the strict rules you need to follow is to rent the unit out to another person for a fair price for at least 14 days. This regulation must be observed for two 12-month periods immediately after the swap.
This workaround was made possible by a safe harbor the IRS outlined in 2008. As long as the replacement property is used as a rental for such a short period over a said length of time, the government will still consider the transaction qualified under IRS code Section 1031.
Remember that you must keep proper documentation regardless of the number of days you become a landlord during the 12 months.
Do Not Overstay in the Property
Even if you can’t officially call your replacement property home until the two 12-month periods are over, you can nevertheless stay in it. The caveat is that you can’t wear out your welcome.
The IRS will not like it if you use your property rental for personal reasons more than 14 days during the 12 months. Or, your stay can’t exceed 10% of the number of days your investment property is rented at a fair price during the 12 months.
Avoid Selling It Within Five Years
The beauty of this transaction is that you will not be married to your replacement property forever. Eventually, you can sell it and still be allowed to use the capital-gain exclusion.
The only prohibition against selling without paying the capital gains tax is a premature sale. You must keep the property as your primary residence for the five years starting on the date it was acquired through a 1031 exchange.
In the end, section 1031 of the IRS code also allows the conversion of a primary residence into a rental property, making it a viable investment. Just like rental-property-to-principal-residence changeovers, such real estate swaps must be executed with specific rules in mind. Make sure you understand them all and seek expert advice to avoid careless mistakes and achieve your goals successfully.