The subject properties in a 1031 exchange must be held for use in trade, business, or for investment purposes. It’s one of the many requirements of a 1031 exchange. However, what if you decide to tweak this rule or maybe defy it entirely? What if you choose to do a 1031 exchange on your primary residence? Is it even possible? Does the IRS permit such transactions under 1031 exchanges? Unfortunately, the answer is a big ‘No.’ And thankfully, you can turn this ‘No’ into ‘Yes.‘ In the following paragraphs, we will go through the consequences of doing a 1031 exchange on primary residences, and finally, I will tell you how you can make this impossible task possible?
Why are Personal Properties Barred from 1031 Exchanges?
There isn’t a specific answer, but there are a few reasons that make it obvious. With 1031 exchanges, the IRS provides investors a unique opportunity to defer capital gains tax on swapping two identical or like-kind properties with each other. As the involved properties remain of the same nature after the transaction, it isn’t considered as a new investment, and hence no capital gains tax. The problem with primary residences is that they are different assets. Therefore, if you sell an investment property and reinvest the proceeds in personal property (home or piece of land), you change the investment, which is taxed normally.
Another reason could be that if you are making money out of an asset, you pay income tax. So, if you were paying taxes before selling your old property, you will keep paying the same tax even after purchasing the new one. However, if you acquire a primary residence in exchange for an investment property, you will not be able to earn income on your property, and there will be no tax. So, why would the IRS let you defer capital gains tax, knowing that you are changing the asset?
If You Prove Your Intent Behind the Investment to the IRS, You Can Invest Your 1031 Proceeds into Personal Property.
The first thing the IRS examines is an investor’s intent behind the investment. What you can do is prove that your old property wasn’t your residence but a rental property. However, you cannot just say, and you will be believed. You will actually have to rent your home to someone else for some time, and it cannot be your family member. Now, what you should concern you is for how long the property needs to be rented?
Most 1031 professionals or experts believe that one to two years should be enough, given you can show the property has been rented for all this time. It’s done, you’ve proved the property you sold was an investment property. You are eligible to defer your capital gains tax. The next job is to identify a new investment property in 45 days.
Use a 1031 exchange timeline calculator to calculate the deadlines.
- Just showing your house is a rental property on papers doesn’t prove it.
- You must rent it out for real to someone who is not related to you.
Check out some high-performing 1031 properties in the 1031 exchange properties list published in the property section of the website.