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

First, Section 121 deals with the IRS rules around the sale of your primary residence whereas Section 1031 deals with investment or business-use property that is exchanged for other like-kind investment or business-use property of equal or greater value.

Section 121 provides that, if you use the home as your primary residence for at least 2 out of the last 5 years and then sell it, you can exclude from your taxable income up to $250,000 in capital gains (if you are single) or up to $500,000 in capital gains (if you are married filing jointly). In other words, you take the first $250,000 or $500,000 in profit totally tax free, and any gain over that is taxable.

  • You can only have one primary residence at a time, other properties that you own are either second homes or investment property.

  • You can use the 121 exclusion no more than once every 2 years.

  • There is no limit to the number of times the 121 exclusion can be taken during your lifetime.

  • The 2 years the property is used as your primary residence does not have to be consecutive; you can aggregate this amount of time over the 5 year period preceding the sale.

  • If a sale occurs and the home was used as your primary residence for less than 2 of the last 5 years, then a partial exclusion may be available if the reason for selling is due to a change in health, place of employment, or some other unforeseen circumstance.

  • If you are married filing jointly, both spouses must reside in the property for at least 2 of the 5 years. However, only one of the spouses needs to be the title owner.

  • Members of the military are eligible for the full exclusion regardless of the length of time they resided in the property, as long as the move is part of service requirements.

Section 121 generally does not apply to investment or business-use property unless a combined 1031 exchange and 121 exclusion (a “1031-121-conversion”) strategy is available.

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.

  • Here, the 121 exclusion is reduced by the number of years it was used as a non-principal residence.

  • Investment or business-use to January, 2009 or the conversion to primary residence is not computed in this reduction.

  • The more time the property is used as your primary residence, the more gain that can be excluded from your taxable income from the 121 exclusion.

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. Revenue Procedure 2005-14.

  • Here, you would sell the investment or business-use property, excluding $250,000 or $500,000 of capital gains from your taxable income and also complete a 1031 exchange for the balance of the transaction to defer the rest of your capital gain, including the depreciation recapture, into the purchase of another like-kind investment or business-use property.

  • This enables you to take the 121 exclusion of $250,000 or $500,000 and then exchange the residual amount in a 1031 exchange.

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