ALLOMONG & ASSOCIATES, P.C.

Phone: 917-946-1031

Email: tim@allomonglaw.com

Office Location: 410 West 48h Street, Suite 2, New York, NY 10036

© 2019 Allomong & Associates, P.C. All Rights Reserved.

Can I Convert a Primary Residence into Investment Property and Swing a 1031 Exchange?

(1) Convert 1031 Exchange Replacement Property to Primary Residence

You buy investment property as part of a 1031 exchange (i.e., the replacement property) and hold it as investment or business-use property for at least 1 to 2 years up front, then convert the property into your primary residence. To use the 121 exclusion on the eventual sale of this primary residence, you must own it for at least 5 years and reside in it for at least 2 out of the 5 years immediately preceding the sale. You then may claim the 121 exclusion upon the sale of this property.

 

(2) Convert Primary Residence to 1031 Exchange Relinquished Property

When the profit on the sale of your primary residence is greater than the 121 exclusion, you might instead convert your primary residence into an investment or business-use property and set it up for a 1031 exchange down the road. You still need to hold the property for investment or business-use for at least 1 or 2 years after converting it to investment or business-use property. If the investment or business-use property is sold within the time period that the 121 exclusion still applies, then IRS allows you to use the tax benefits both Section 121 and Section 1031.

Can sale proceeds from a “flipped property” be tax-deferred and used in a 1031 exchange to purchase other investment property?

Not so fast. To qualify for a 1031 exchange, you must hold the property after the rehab/renovation phase for (1) investment purposes, or (2) productive use in a trade or business (e.g., the business of renting). There is no “holding period” defined in the tax code, but professionals agree that 1 to 2 years is adequate (but, if an unsolicited offer is received on a property held for less than 1 year, and acceptance is economically solid, then the 1 or 2 years standard holding consensus is relaxed).

 

The exchanger’s “principal intent” to owning the property is critically important here. If the property was acquired with the principal intent to rehab and resell (i.e., a traditional flip) then the property is considered business inventory, which is ineligible for a 1031 exchange and profits from its sale are taxed as either ordinary income or long-term capital-gains income.

 

In the event of an audit, the IRS looks at many factors, such as why the property was bought, improvements made to it, length of ownership, and the exchanger’s ordinary business actions (is it consistent with real estate investing or selling flipped houses?). Itemizing the property on Schedule E, including rental revenues, expenses, and depreciation is a great way to prove 1031 exchange eligible ownership.

Personal Property Can Also be Part of a 1031 Exchange?

1031 exchanges may also include non-real estate assets (personal property) such as tangible hotel beds, business equipment, franchise licenses, or domain names. These are not individual belongings or personal use assets, they must have been held for productive use in a trade or business or for investment purposes. The other 1031 exchange requirements still apply.

 

Under IRC §179, personal property depreciates quickly for tax purposes over short periods of time (called "bonus depreciation"). The spread between its taxable basis (usually $0) and its FMV upon sale generates a taxable event that is taxed at depreciation recapture or ordinary income rates, which can be upwards of 35%. This situation occurs often with depreciable business use assets.

Can a 1031 Exchange Overlap the April Income Tax Filing Deadline?

Section 1031 exchanges must be completed within 180 days after the sale of replacement property. The exception is when the April income tax filing deadline falls within that 180 day period, in which case the April filing deadline trumps the 180 day deadline. In other words, your 1031 closing deadline is now the April tax filing deadline.

 

To realize the full 180 day exchange period, you must file an extension with the IRS. If you already filed your tax return, you can still claim your 1031 exchange on an amended tax return. Your best idea is to discuss this with your CPA or tax advisor, as well as your Qualified Intermediary, immediately.

What is a "Reverse 1031 Exchange?"

Reverse exchanges are commonly structured under the guidelines set forth under IRS Revenue Procedure 2000-37. A safe harbor is available for reverse exchanges under the following conditions:

 

  • The replacement property is purchased in the name of an "exchange accomodation titleholder" (EAT), which is an LLC formed by 1031trx LLC for the purpose of holding title to the property (e.g., "parking" the property). The EAT borrows money from the exchangor (and/or a lender) to acquire title to the replacement property and then holds title to the replacement property until the eventual sale of the relinquished property.

  • The relinquished property is identified within 45 days of the purchase of the replacement property.

  • The relinquished property must be sold within 180 days of the purchase of the replacement property.

  •  

    Revenue Procedure 2000-37 prohibits the exchangor from having ownership of the relinquished and replacement property simultaneously. The exchanger must have the funds available to purchase the replacement property before selling the relinquished property (if financing, the lender must be willing to lend the money to the EAT for the purchase). 1031trx LLC creates a lease between the EAT and the exchangor so the exchangor has access to the parked property until the 1031 reverse exchange is finalized.

    Can Mixed-Use Property Qualify for 1031 Exchanges?

    Yes. Mixed-use property (e.g., property that the taxpayer uses for both income production/investment and for personal residence) may qualify for a tax-deferred 1031 exchange. A careful valuation that separates the business value from the personal residence value is necessary. Only the income producing/investment portion of the property may be exchanged and the replacement property must be like-kind property used for income production or investment. The same exchange requirements must be met with respect to that tax-free exchange, and another mixed-use property may even be purchased as long as the rules are followed.

     

    As for the personal residence portion of mixed-use property, Section 121 exempts up to $250,000.00 of gain from taxation ($500,000.00 for a married couple filing jointly). The taxpayer must have lived in the residence for 2 of the last 5 years and may only claim this exemption once every 2 years.

    What is the Capital Gains Tax and How's it Calculated?

    Investors owe federal capital gains taxes on their gains depending on their tax bracket. The tax rate varies between short-term (the sale of an asset held for one year or less is taxed at the same rate as ordinary income) and long-term gains (the sale an asset you held for one year or more is taxed at long-term capital gains tax rates of 0, 15, and 20 percent).

     

    A gain (or loss) resulting from the sale of an asset is calculated by subtracting the "cost basis" of the asset from the amount realized on the sale. The cost basis is equal to the purchase price, adjusted for certain factors such as fees paid (brokerage fees, certain legal fees, sales fees) and depreciation.

     

    The "Obama-surcharge" is an additional 3.8% tax on net investment income (includes interest, dividends, capital gains, retirement income and income from partnerships), which applies to taxpayers earning net investment income exceeding $200,000 for single filers and $250,000 for married couples filing jointly.

    Do Vacation Homes Qualify as 1031 Exchange Investment Property?

    Generally, no. Residences held solely for personal use (i.e., never rented out) are not 1031 exchangeable. However, IRS Revenue Procedure 2008-16 states that a vacation home qualifies as eligible 1031 exchange investment property if:

     

    • it is owned by the taxpayer for at least 2 years prior to or after the 1031 exchange period; and

    • in each of those 2 years, it was rented out for 14 days or more at fair market rent and personal use of these vacation homes must be no greater than 14 overnights or 10% of the days rented per year. If maintenance is performed when staying at the investment property, those overnights are not counted towards the 14 overnights permitted.

     

    Reporting the vacation property on Schedule A is a clear indication the property is not an investment but a second home. Vacation properties can be converted to primary homes following specific IRS guidelines, and vice versa.

    When Can an Exchanger Receive Funds from the 1031 Exchange Account?

    Sometimes, investors decide not to proceed with the 1031 exchange after selling the relinquished property -- or they have acquired some replacement property and decide not to acquire additional property with their relinquished property sale proceeds. They then, understandibly, expect the immediate return of the proceeds.

     

    A Qualified Intermediary is generally only able to release the proceeds to the exchanger upon the expiration of the 180 day exchange period; if no replacement property is identified within 45 days; or upon the acquisition of all identified replacement property to which the exchangeris entitled under the exchange agreement.

     

    Otherwise, a Qualified Intermediary may only release the proceeds when a material substantial contingency to purchasing identified replacement property occurs, which is beyond the control of the exchanger and disqualified persons.

    Crowdfunding 1031 Exchanges: Can it Benefit a 1031 Exchanger?

    Crowdfunding is the funding of a large project by raising money from a group of individual investors via a third-party platform. The JOBS Act now permits crowdfunding platforms to raise funds through the sale of securities to both accredited investors and non-accredited investors, without having to register with the SEC, under certain circumstances.

     

    On October 30, 2015, the SEC eased the restrictions on crowdfunding platforms' ability to reach non-accredited investors. Households with an income of less than $100k can invest the greater of $2k or 5% of its net worth or annual income. Households with an income of more than $100k can invest 10% of the lesser of their net worth or income per year, but not more than $100k.

     

    Real estate crowdfunding platforms can assist 1031 exchangers with partial interests in large investment projects, still qualifying as 1031 replacement property. See the latest updates on real estate crowdfunding here.

    1/2

    Please reload