It’s the time of year when we all start thinking about getting away in the summer. If you’re thinking of moving to your favorite R&R spot, here’s a strategy worth knowing.
After one too many Northeast winters, Mike decided it was time to make his main home in sunny Florida. He wanted to sell his apartment building and use the funds to purchase a Florida home. A 1031 exchange would defer the taxes, but he can’t exchange into a personal residence… or can he?
A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting proceeds from the sale of an investment property into another like-kind property (any real estate for any other real estate, as long as it’s for investment purposes).
While many investors use this strategy to grow their portfolios, a lesser-known approach allows them to acquire a vacation home through a 1031 exchange and later convert it into a personal residence, eventually minimizing their tax liability upon sale.
Here’s what Mike did.
Step 1: Acquire the Vacation Home as an Investment Property
To qualify for a 1031 exchange, the replacement property must initially be classified as an investment property. Mike can’t immediately use it as a personal residence — instead, the IRS requires the property be rented out to tenants for a reasonable period.
Generally, the safe harbor guideline suggests the property should be rented for at least 14 days per year at fair market value, for a minimum of two years. You can rent it to family at fair market rental rates, or to your own corporation for company retreats and business use.
During this period, Mike should also limit personal use of the property to no more than 14 days per year, or 10% of the total days it’s rented, whichever is greater. Keeping thorough documentation of rental activity, expenses, and personal use is crucial to make sure the 1031 is solid and demonstrates intent as a rental property.
Step 2: Convert the Property to a Personal Residence
After the required rental period, Mike can begin converting the property into a primary residence. Once converted, he needs to make it his primary residence for at least two more years to qualify for the Section 121 home sale exclusion.
This exclusion allows individuals to exclude up to $250,000 ($500,000 for married couples) of capital gains on the sale of a primary residence, provided they’ve lived in it for at least two of the last five years before the sale.
Step 3: Selling the Property and Reducing Tax Liability
When Mike discovers he loves fishing and doesn’t want to leave Florida, he decides to buy a bigger residence.
When he sells the property, a portion of the capital gains may still be subject to tax due to depreciation recapture and the pro-rata application of the Section 121 exclusion. The IRS calculates the exclusion based on the ratio of time the property was used as a primary residence versus the total ownership period, with any depreciation taken during the rental period remaining taxable.
For example, if Mike owns a property for 10 years, rents it for the first four, and lives in it for the remaining six, he can exclude only a proportional amount of the capital gains (6/10 of the gain) under Section 121. The portion attributable to the rental period remains taxable.
Since Florida prices have climbed, Mike’s condo is worth $1M when he wants to sell. He purchased it for $500,000, but the basis in his property is $250,000, since the basis from his 1031 exchange property in PA carried over in the exchange. That puts his capital gain at $750,000, of which 6/10 — $450,000 — is covered by Mike and his wife’s personal exemption. Mike will pay tax on the remaining $300,000 at long-term capital gains rates.
(For simplicity, we’ve left out depreciation recapture, which would also need to be factored in. Every investor should seek counsel from their CPA or tax advisor.)
Key Considerations and Compliance
To ensure the success of this strategy, investors should strictly adhere to IRS guidelines for rental use before conversion, maintain accurate records of rental income, expenses, and personal use, and consult with a tax professional to navigate the complexities of the 1031 exchange and Section 121 exclusion.
By carefully planning and executing a 1031 exchange into a vacation home, real estate investors can enjoy the benefits of tax deferral, generate rental income, and eventually convert the property into a personal residence while minimizing capital gains taxes upon sale.
Many investors we work with appreciate the big-picture thinking we provide to help them maximize their investment returns and reduce taxes. Contact us today to plan your next smart move to grow and protect your investments.
