Anyone who has managed or sold real estate properties is keenly aware of at least one of life’s few guarantees: taxes. Whether you make a record-breaking return or a modest profit, the Internal Revenue Service inevitably appears to collect the government’s cut.
Some savvy property owners, however, have discovered the benefits of using a 1031 exchange as a means of delaying capital gains taxes they would normally owe — potentially into perpetuity. While 1031 exchanges are almost always restricted to investment properties, some property owners still ask if there’s a way to extend this opportunity to primary residences.
While the IRS’s stance is an explicit “no,” as with most Internal Revenue Codes, Section 1031— the particular tax code that addresses these transactions — has a few exceptions that open up the possibility of using a 1031 exchange on a primary residence. Below, we will give you a foundational understanding of the process before explaining how you can use a 1031 exchange for your primary residence.
1031 Exchange Explained
Under normal circumstances, capital gains taxes are an unavoidable part of the property sales process. Once you have closed the sale, the IRS expects taxes amounting to 15% or 25%, based on factors like the total sale amount, your annual income, and a 3.8% surtax for higher-income individuals.
However, Internal Revenue Code Section 1031 allows real estate investors to replace one property with what the IRS describes as another “like-kind” property. This allows sellers to defer capital gains taxes that would otherwise have been due during income tax season.
The basic rules of a 1031 exchange are:
|Simplified 1031 Exchange Rules|
|1||The old property and the new property must be “like-kind.”|
|2||The new property must be used for investment or business purposes.|
|3||The new property must have equal or greater value than the previous one, or some portion of the exchange may be taxable|
|4||Any cash or proceeds from the sale must be handled and held by an intermediary, not the seller.|
|5||The name deeded on the new property title must match that of the sold property.|
|6||The new property must be identified and communicated to an intermediary within 45 days of the closing date for the sale of the old property.|
|7||The new property purchase must be closed, and the purchase must be funded by the intermediary, within 180 days of closing the sale on the old property.|
|8||The 45-day and 180-day windows occur concurrently. In other words, if you identify a new property 25 days after selling your old property, you’ll have 155 days left to purchase that new property.|
What essentially occurs during a 1031 exchange is that you sell one property and use the sale proceeds to purchase a like-kind property, which in this case, is another investment property.
By doing so, you effectively push back the due date for your capital gains taxes until you sell the new property. What’s more, no law or ordinance prevents you from swapping out your new property again for another when you decide to sell, effectively eliminating your liability for capital gains taxes! Neat, huh?
Some things in life sound too good to be true, and it’s always a good idea to do your own research if you’re uncertain. Fortunately, this is not the case with a 1031 exchange because it allows you to use a legal exception in the Internal Revenue Code to your advantage.
Using a 1031 Exchange on a Primary Residence
So why does all of this matter if you’re selling a primary residence and not an investment property? Normally the IRS does not allow 1031 exchanges on primary residences. This is because 1031 exchanges are meant to be used on investment properties or properties held for business purposes and primary residences are used as your shelter.
However, as with many things in the Internal Revenue Code, there are exceptions to the rule and ways you can use a 1031 exchange for a primary residence.
Converting a Primary Residence Into an Investment Property
How often has someone mentioned they’ve decided to buy a new home and just rent out the old one to tenants? Perhaps you’ve even done this yourself as it’s a common path of entry to real estate investing for many Americans.
One way you can conduct a 1031 exchange on your primary residence is by converting it into an investment property.
There are a couple of stipulations, of course:
- The IRS does not explicitly state how long a property must be held for rental purposes to be used for a 1031 exchange. A general rule of thumb, upon which many CPAs would agree, is that you should rent the property out at fair market rates for at least two years.
- You cannot reside at your property in any capacity while it’s in use as a rental. It must be used specifically for investment purposes.
Section 121 Exclusion
Another option for saving taxes is to exclude part of the capital gain using what’s called a Section 121 exclusion. While not quite the same as a 1031 exchange, Section 121 exclusions can give you additional elbow room for capital gains taxes on primary residences.
Instead of being a method of tax deferral, it allows you to exclude gains on the sale of a primary residence of up to $250,000 for single filers and $500,000 for joint filers. To use Section 121, you need to have resided on the property for at least two of the previous five years, although it doesn’t have to be a continuous period.
There is one huge caveat with Section 121 exclusions: homeowners can only claim this exclusion once every two years.
Canyon View Capital Makes 1031 Exchanges Easy
Now that you know more about using a 1031 exchange on a primary residence, you’ll want to partner with experts. Though 1031 exchanges and similar strategies can yield impressive benefits, they can also be extremely complicated to initiate and execute successfully. That’s why even seasoned investors should consider seeking professional advice. The Canyon View Capital team has an extensive understanding of real estate, investment strategies, and tax laws to ensure your 1031 exchange goes through without a hitch.
The CVC team works diligently to help investors like you navigate the tumultuous waters of real estate investing. For over four decades, CVC principals have managed a portfolio of over $1 billion1 in multi-family real estate and shared our expertise with investors.
The professionals at CVC can help simplify the process by rolling your sale proceeds into one of our multifamily properties in America’s Heartland. At CVC, we work with you step-by-step to help you enjoy steady returns on risk-averse properties while also serving as your go-to resource for all things related to taxes and real estate.
Still hazy on the details of a 1031 Exchange for a primary residence?
Canyon View Capital can show you the way! We will walk you through every step of your 1031 exchange, and our in-house professionals will always answer your questions honestly, completely, and promptly. CVC will help you cut through the red tape, no matter how sticky it gets. Contact Canyon View Capital TODAY!
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Gary Rauscher, President
When Gary joined CVC in 2007, he brought more than a decade of in-depth accounting and tax experience, first as a CPA, and later as the CFO for a venture capital fund. As President, Gary manages all property refinances, acquisitions, and dispositions. He works directly with banks, brokers, attorneys, and lenders to ensure a successful close for each CVC property. His knowledge of our funds’ complexity makes him a respected executive sounding board and an invaluable financial advisor.