Convert Your 1031 Exchange Property into a Primary Residence

As per the rules established by the IRS, to qualify for a 1031 exchange (also known as a like-kind exchange), the property that you give up (relinquished property) must be held for use in trade, business, or for investment purposes. Technically, personal property or primary residence is not held for investment or use in a trade or business. Hence, it does not qualify for a 1031 exchange. Property used in both ways may partially qualify for a 1031 exchange - for example, a duplex. Say, you live in its one unit and rent out the other one. In that case, you may be able to do a partial 1031 exchange. Therefore, neither the relinquished property nor the replacement property can be used as a personal residence under a 1031 exchange. Also, holding a home just because its value will rise after some time does not constitute investment.

The main thing is your intent with which you acquire the replacement property. If you intend to use it as an investment property and not to settle into it in the first place, then you are good to go. But how can you prove your intent? The best way is to use the property for investment for a significant amount of time after acquiring it or meet the safe harbor test discussed below. If you put the house on rent for at least a year, then you have proved that you bought the property with investment intent. On the other hand, if you merely put up a good show by listing the property for rent at a price that is significantly higher than its market value, the IRS will get you.

Following are other common ways through which you can prove your intent:

•Make no plans for your primary residence or vacation home immediately before or after the exchange.
•Don’t settle into the replacement property soon after the exchange. Not even temporarily.
•Make sure your replacement property contract isn't contingent on the sale of your primary residence.
•Use a reasonable number of listings for renting your property at a marketable rental amount.
•Keep a record of how you come up with the rent amount for your property that you lease out.
•Don’t begin preparing the house for your personal use immediately after acquiring it.
•Ensure that the restrictive clauses associated with the replacement property allow it to be rented out.
•Document your efforts to rent out the property, including name and contact information of potential tenants who have seen it.
•If you move into the property because of any avoidable reason, make sure you've documents to support your decision. Losing your job, getting sick, divorce, marriage, or need to look after elderly parents, there could be a plethora of reasons.

As we've mentioned above, the IRS has created a safe harbor for determining the amount of time for which a replacement property must be held as a rental before it can be converted into a primary residence or vacation home without invalidating the prior exchange. The investor must hold the replacement property for at least 24 months after the exchange, and in each of the two 12-month periods: (1) the investor must rent out the replacement property to a tenant at a fair rental for at least 14 days or more; and (2) the investor must not use the replacement property for living for more than 14 days or 10% of the number of days during the 12-month period when the property is rented at fair rental. You can rent the property to a family member as a principal residence as long as monthly rent is paid.

As you can see, it's possible to convert a 1031 exchange property into a primary residence if taken proper measures. However, you may want to talk to your advisor or a 1031 exchange expert before planning your investment.