Can I Move Into Property Bought In a 1031 Exchange?

It depends. I've probably mentioned this before, but that is my favorite technical answer to many 1031 tax deferred exchange related questions, or any income tax related question for that matter. It depends is often appropriate because the income tax laws and regulations are not always black and white. And, this question is no different, so the answer "It Depends" is so fitting.

Income Tax Savings
This question actually makes a lot of sense. It can be an incredible income tax planning strategy that can save an investor quite a bit on taxes. Investors can sell investment property and acquire replacement property and ultimately convert the property into their own primary residence. They can sell their primary residence after a certain amount of time and qualify for a tax free exclusion under Section 121 of the Internal Revenue Code. The timing of each step and the amount of gain to be excluded should be planned carefully, but it allows investors to turn tax-deferred income into tax free income.

1031 Tax Deferred Exchange
The 1031 tax deferred exchange requires that you sell property that was held for rental, investment or used in your business and that you acquire replacement property that is also to be held for rental, investment or also used in your business operation. The 1031 tax deferred exchange will only defer the payment of your capital gain taxes.

121 Tax Free Exclusion
Homeowners can sell their primary residence and exclude up to $250,000 if they are single or up to $500,000 if they are married from taxable income as long as they have owned and lived in the property as their primary residence for at least a total of 24 months out of the last 60 months. The 121 exclusion will only exclude capital gain taxes and will not exclude any depreciation recapture taxes that might be due.

The Reason that It Depends
There are a number of issues involved here, so I will address each of the issues independently. The issue vary depending on your individual circumstances.

First, the investor must complete his or her 1031 tax deferred exchange. Once they have completed their 1031 exchange they need to hold the acquired replacement property long enough to demonstrate they had the intent to hold the property for investment. Generally, most 1031 tax deferred exchange experts recommend at least 12 months and preferrably at least 24 months in order to demonstrate your intent to hold the property.

Second, the investor must move into the property and convert it into their primary residence and live in the property as their primary residence for at least 24 months in order to qualify for the tax free exclusion under Section 121 of the Internal Revenue Code.

Third, because the property was acquired as part of a 1031 tax deferred exchange, there is a five (5) holding requirement in order to take advantage of the 121 exclusion. This requirement would be satisfied if the investor rented the property for three (3) years and then moved into it and lived in it as his or her primary residence for two (2) years resulting in a total of five (5) years. This issue does not apply if you did not acquire the property as part of a 1031 exchange.

Fourth, because the property was held as rental property first, the amount of gain that can be excluded on a tax free basis after January 1, 2009 will be reduced by the amount of time that the property was held for non-qualified use (i.e. use other than as a primary residence). This change was included in the Housing and Economic Recovery Act of 2008.

That was a windy answer, and can be confusing. Please feel free to email me or call me with any specific questions that you might have.