The Internal Revenue Code is clear that property used primarily for personal use - a primary residence, a second home or vacation home - does not qualify for section 1031 like-kind exchange treatment. However, investors can combine the tax deferral benefits of section 1031 exchange with the tax benefits of the Code Section 121 exclusion for sale of a personal residence to minimize their tax burden.
Under the Section 121 rules, a taxpayer can sell property owned and used as their primary residence and exclude up to $500,000 (if married filing a joint return) or $250,000 (if single). The taxpayer must live in the primary residence for at least 24 months out of the last 60 months. This rule, changed in May 1997, allows a full exclusion every two years. Tax Rules on Sale of Personal Residence should be reviewed to ensure the guidelines are met.
Investors can benefit by combining 1031 exchange rules with the primary residence exclusion. By exchanging investment property into a replacement property that is held for investment purposes and subsequently, after a period of time, converting the rental property into a primary residence, a real estate investor can, not only defer their capital gains, they can exclude a significant portion of their tax burden. How to Roll Over Investment Property to Personal Residences explains the strategy used to benefit from this strategy.
New rules regarding the conversion of 1031 exchange property into primary residences were put in place in 2004. A five-year ownership requirement involving the tax-free sale of a personal residence for replacement property in a tax-deferred like-kind exchange was created. A personal residence that was initially acquired as a Section 1031 replacement property and subsequently converted to a personal residence is required to be owned by the taxpayer for five years before the home is eligible for a tax free sale under Code Section 121. Five Year Ownership Requirement on Sale of Personal Residence Involved In a Previous Exchange explains this new requirement.
Vacation property may also qualify for an exchange. However, an owner of vacation property must be able to show that his intent was to hold the real estate for investment purposes and not for personal use. In 2008, the IRS issued Rev. Proc. 2008-16 which established a Safe Harbor for Exchanges of Vacation Homes and Conversions to or from Personal Residences.
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