The subject of questions I get from clients seems to go in cycles – I won’t get any questions about a particular subject for a long time, and then all of a sudden I’ll get a lot of questions about that subject—and from different parts of the country. Such is the case with the subject of this article: “can you buy a residence as your 1031 replacement property and then move into it?”

by Gary Gorman founding partner, 1031 Exchange Experts, LLC

Section 1031 rolls the taxable gain from the sale of your old investment property over to your new. The key word here is, “investment.” If you sell bare land and buy a rental house, Section 1031 rolls the gain on the land over to the house.

“...if you get the chance to take money off the table tax-free —take it...!”

So what happens if you’ve done exactly that (land into a house) and now you want to move into the house? You’re allowed to do this provided there is no question that you bought the rental house for investment – if you move into it right away you didn’t buy it for investment, you bought it as a house to live in, which does not qualify for 1031 treatment. To qualify the property as an investment you need to rent it, or seriously try to rent it, for at least a year and a day (unless the house is a vacation or second home in which case there are special rules that will extend the time frame to two years).

Let’s take a hypothetical situation and walk through the various tax rules that impact the transaction. Fred and Sue sell a piece of land in Colorado in January of 2005, do a 1031 exchange and buy a house in Tucson, Arizona that they plan on retiring to in a few years. Their plan is to rent the house, and in fact they are able to find a tenant who rents the house on a two year lease. Assuming that they met all the other requirements for a 1031 exchange, they owe no tax on the sale of the land.

Two years later, at the end of 2006, the tenant informs them that the lease will not be renewed, and vacates the property. This coincides nicely with Fred and Sue’s retirement plans and they sell their Colorado house and move into the Tucson house at the beginning of 2007. Although they have substantial appreciation on the Tucson house, does moving into it and converting it from an investment property to a personal residence trigger the gain? No, the gain is not triggered until they sell it.

Fred and Sue live in the house for a couple of years (until the end of 2008 - so they’ve owned it for a total of four years), and they decide they would like to sell it and move to Hawaii. Is the gain taxable? Yes – because they bought the house as their rollover property in a 1031 exchange the law requires that they own it at least five years before they can take the $500,000 exclusion (because they are married) from the sale of a primary residence.

Should Fred and Sue continue to live in the house until the end of 2009, they will have met the five-year ownership requirement, as well as the requirement that the house be their primary residence for two of the five years before they sell it. After that, they can sell the house and take their $500,000 exclusion even though a substantial amount of the appreciation happened before they moved into it (while the property was 1031 property). Assuming the gain was less than $500,000, the only thing they would pay tax on would be the depreciation that they took on the house while it was a rental, which they are required to recapture.

What happens if Fred and Sue move to Hawaii at the end of 2008 and rent out the house during 2009, and then sell it? They’ve still met their five year ownership requirement, as well as the requirement that they occupy the house for two of the five years before they sell it, so they could still take their $500,000 exclusion, but two additional rules kick in.

First, because the property was rental property the year before they sold it, they can choose between doing another 1031 exchange or taking their $500,000 exclusion. My advice, if you have the chance to take money off the table tax free – always take it! In other words, take the $500,000 exclusion and don’t do a 1031 exchange.

Secondly, because the property was rental property in the early years before they moved into it, there is a new law that will convert the post 2008 rental period into taxable gain.

The rules of doing a 1031 exchange are strict, and the tax code can be a tangled web of complexity. Be sure to call a competent 1031 exchange expert as early as possible to help you navigate the procedure. Calling NOW (even before you think you need to) helps to ensure we have plenty of time to properly structure a transaction that takes advantage of all the different tax codes available in your favor.