1031 exchanges involve property you hold for investment, not your personal residence.  So why write an article about doing a 1031 exchange on your personal residence?  Everyone knows that your personal residence does not qualify for a 1031 exchange!  Or does it?

by Author Gary Gorman Founding Partner, The 1031 Exchange Experts

When you sell a residence you’ve lived in for two of the last five years, $500,000 of the gain is tax free if you’re married; ($250,000 if you are single).  This is your personal residence, which does not have anything to do with 1031 exchanges, right?  However it might.  You know the two-of-the-last-five-years rule, but did you ever ask yourself what the property was used for during the other three years?

Let’s say Fred and Sue buy a house that they live in during years one and two.  At the end of year two, they move out and turn the house into a rental property and rent it out for years three, four and five.  When they sell it at the end of year five, does the property qualify for the personal residence exclusion?  Yes, because Fred and Sue lived there for two of the five years preceding the sale.  Does it also qualify for a 1031 exchange?  Yes, because it was investment property for the last year-and-a-day before they sold it. 

When two IRS code sections overlap, like the sale of a personal residence and Section 1031 do in this example, the IRS lets you pick the code section that gives you the biggest benefit.  So which should you pick? In this example, Fred and Sue should treat the transaction as the sale of a personal residence because doing so will allow them to take up to $500,000 of their gain off the table tax free – they’ll never have to pay tax on this money again.  If they treated the sale as a 1031 exchange, they would end up paying tax on the gain someday even though the gain would be deferred right now.

What if the gain from the sale of their house exceeds their personal residence exclusion?  Then Fred and Sue are allowed to maximize their exclusion and can roll the rest of the gain over in a 1031 exchange.  For example, assume that they sell the house for a gain of $600,000.  They first apply their personal residence exclusion of $500,000, which leaves a gain of $100,000.  Then they may rollover the $100,000 in a 1031 exchange to avoid being taxed on any of it.

Now let’s take a different example showing a different interplay of these two code sections: Let’s say Fred and Sue are selling a four-plex that they’ve owned for more than two years.  During the time they owned it, they lived in one unit as their residence and rented out the other three units.  In situations like this, they have a transaction that is a combination of both code sections – they have both the sale of their personal residence (for one fourth of the sale), and a 1031 exchange (for three fourths of the sale).  In effect, they have two transactions with this one sale.

So just because you are selling a residential property, there may still be a 1031 exchange angle that will help you defer the tax.