If you sell an investment property, you will get hit with an outsized bill , especially if you sell it for an outsized profit. However, a 1031 exchange allows you to use the proceeds from that investment property to buy for an additional and defer any liabilities within the method .

The IRS stipulates that a 1031 exchange must be performed with two “like-kind” properties, which suggests that you simply simply got to sell one property you held as an investment so on buy another property you plan to hold as an investment. So, during this sense, you cannot use a 1031 exchange to buy for a primary residence with proceeds from an investment property.

However, there's no rule that says the newly acquired property must be used as an investment property forever. It's entirely possible to buy for an investment property through a 1031 exchange, rent it to tenants for a couple of time, then enter the property yourself.

For example, as an example that you simply simply want to retire and move to the beach during a couple of years. you'll sell an investment property that you simply simply currently own, buy a property at the beach employing a 1031 exchange, and rent it out until you are able to retire.

The capital gains tax exclusion for primary residences
Here's why this may be such a lucrative strategy. A 1031 exchange allows you to defer capital gains taxes until you sell the newly acquired property. However, if that property could also be a principal residence at the time you ultimately sell it, you'd possibly be able to avoid variety of your capital gains taxes permanently.

In most cases, once you sell an asset for quite you bought it, you'll have a taxable gain . And as we've mentioned, this is often often typically the case when it involves land .

However, if the important estate you sell was your primary residence, this is often not necessarily the case. The IRS allows you to exclude capital gains from the sale of your primary home, up to $250,000 for single taxpayers and $500,000 for married couples filing joint returns. as an example , if you and your spouse acquired your primary residence for $300,000, you'll not got to pay a dime of capital gains tax unless you sell it for net proceeds of quite $800,000.

To qualify for the primary residence exclusion, the property must are owned and used as your principal residence for a minimum of two of the five years before the sale. The ownership and usage requirements don't necessarily need to be met with the same two years, and there are exceptions that apply to active military personnel who got to relocate as a neighborhood of their duties. and you will only use the exclusion once every two years.

3 belongings you bought to understand before proceeding
Before you actually put a thought in motion to sell one rental property to buy for one to eventually sleep in , there are a few of rules you'd wish to understand . Specifically, lawmakers have taken steps to shut this loophole, and while it still are often an efficient tax strategy, it is not just a huge “pay no taxes” pass. The three most significant rules you'd wish to understand before converting a property you acquired during a 1031 exchange into a primary residence are:

Depreciation recapture cannot be permanently excluded
Only some of your capital gains qualify for the exclusion
You must hold the property for a minimum of 5 years
Let's explore each of these in additional detail:

Depreciation recapture cannot be permanently excluded
When you sell an investment property, there are two kinds of tax you'd possibly got to pay:

Capital gains tax applies to internet profit you earn on the sale, relative to your cost basis within the property.
Depreciation recapture occurs once you sell an investment property, as your cumulative depreciation you've claimed during your ownership period is taken under consideration to be taxable income upon the sale.
When you complete a 1031 exchange, you'll defer both kinds of taxes. However, once you propose to use the primary residence exclusion on a property you acquired through a 1031 exchange and later sold, you'll still got to pay any applicable depreciation recapture tax on both properties.

The short version: the primary residence exclusion only applies to capital gains, not depreciation recapture.

Only some of your capital gains may qualify for the exclusion
When you eventually sell the property after using it as a primary residence, you will only exclude capital gains which can be attributed to the time during which the property was used as your residence.

In other words, if you own a property for 10 years, but only used it as your primary residence for four, you will only use 40% of the capital gains toward the primary residence exclusion. And to make it slightly more complicated, any use before 2009 are often used toward the exclusion.

Consider this simplified example. as an example you bought a property in 2005 for $100,000. You sell it in 2009 for $200,000 and use the proceeds to end a 1031 exchange to a replacement property. In 2013, you progress into the new property and live there for two years, selling it in 2015 for $300,000. this provides you a $200,000 total gain over a 10-year ownership period. you'll consider the four years before 2009 also because the 2 years you lived within the property for the capital gains exclusion (a total of six years). So, you'll exclude 60% of your capital gains, or $120,000 from taxation. the other $80,000 are getting to be considered a long-term gain and may be taxed accordingly.

It's also worth mentioning that any use after you reside within the property are often considered for the exclusion.