How to Convert Rental Property to a Primary Residence

Converting a rental property into a primary residence is a significant financial move with potential tax implications that necessitate careful planning. By leveraging tools like Section 121 of the IRS code and 1031 exchanges, homeowners can navigate the complexities of this process. However, understanding the intricacies of these laws is crucial. Here’s how to convert a rental property into a primary residence the right way.

A financial advisor can help optimize your real estate portfolio to lower your tax liability.

How to Convert Rental Property to a Primary Residence

Converting a rental property into a primary residence is possible, but doing so can have unwanted tax implications if you go in blind. Fortunately, tax exemptions are available through Section 121 of the IRS code and 1031 exchanges. Depending on the situation, you can apply one or both of these tools to minimize your tax burden when converting a rental property. Here are how these two tools work:

1. Section 121 Exclusion

Section 121 of the Internal Revenue Code exempts up to $250,000 (or $500,000 for a married couple filing jointly) of capital gains from the sale of a primary residence if you’ve owned and lived in the property for at least two of the past five years.

To qualify, you need to have owned the property and lived in it as your primary residence for at least two years out of the five years leading up to the sale. While a 1031 exchange affects this exclusion, they can work together to create a tax advantage, as you’ll see in later sections.

2. 1031 Exchange

A 1031 exchange, also known as a like-kind exchange, allows you to delay capital gains taxes when selling an investment property by purchasing a similar property with the proceeds. You can defer these taxes in perpetuity every time you sell an investment property by acquiring other investment properties of like kind.

The process runs on strict deadlines. Once the sale closes, you have 45 days to identify potential replacement properties. You can name a single property at the same price or multiple properties with a combined value of 200% or less of what you sold. From there, you have 180 days from the original sale to close on the replacement. A qualified intermediary is typically required to hold the sale proceeds during this window. If the seller takes possession of the funds at any point between selling the original property and purchasing the replacement, the exchange may be disqualified and the deferred taxes become due.

Tax Implications and Limitations

Section 121 exclusions and 1031 exchanges are complex financial moves with various rules and boundaries homeowners must follow to avoid penalties. Here’s what to remember: 

Proof of Intent to Rent

The IRS pays close attention to intent when a rental property acquired through a 1031 exchange is later converted to a primary residence. If the IRS determines that the exchange was completed with the sole purpose of turning the replacement property into your personal home rather than holding it as an investment, the entire exchange can be disallowed and the deferred taxes become due immediately.

To protect the exchange, document your genuine intent to use the property as a rental from the time you acquired it. This means keeping signed rental agreements with tenants, copies of public listings advertising the property for rent and financial records showing rental income collected. The stronger your paper trail showing actual rental activity, the harder it is for the IRS to argue the property was never a legitimate investment. Without that documentation, you risk losing the tax deferral the exchange was designed to provide.

Initial Rental Unit Use and Subsequent Residency Length

Renting out a 1031 exchange property complicates your ability to claim the Section 121 exclusion later because you must fulfill the requirements for both. Doing so is still possible, but you must complete a 24-month holding period where you rent out the property instead of living in it. 

Specifically, every 12 months, you can live in the property for 14 days or 10% of the days you rented out the property, whichever is less. You must complete this 12-month process twice so your ownership lasts for 24 months without using the property as your primary residence. 

After this period expires, you can move into the property and make it your home. Then, to qualify for a Section 121 exclusion, you must treat the property as your primary residence for at least two years out of the five years that precede selling the home. 

Single Ownership

The Section 121 exclusion is available to individuals or married couples filing jointly. This tax break is unavailable if a company, group, or business partnership owns the property. 

Depreciation Recapture

Owning a rental property allows you to deduct a portion of the property’s value each year through depreciation. However, the total amount you have depreciated in previous years is included as taxable income in the year you sell the property. The amount included in taxable income is called depreciation recapture, and it is taxed at your marginal tax bracket or 25%, whichever is larger.

For example, if you claimed $50,000 in depreciation deductions over the years you rented the property and you are in the 25% recapture bracket when you sell, the recapture adds $50,000 to your taxable income for the year, resulting in roughly $12,500 in additional taxes. You do not owe the full $50,000 back to the IRS. You owe taxes on that amount at the applicable rate. This recapture can reduce the benefit of the Section 121 exclusion you receive when selling the property as your primary residence, so it is important to factor it into your tax planning before you sell.

Five-Year Holding Period for Section 121

Converting a 1031 exchange property into a primary residence and then selling it under the Section 121 exclusion requires meeting three conditions.

First, you must rent the property for at least two years after completing the 1031 exchange. This establishes the property as a legitimate investment and protects the exchange from being disqualified by the IRS.

Second, you must hold the property for at least five years from the date you acquired it through the 1031 exchange. Selling before the five-year mark disqualifies you from claiming the Section 121 exclusion on that property.

Third, you must have used the property as your primary residence for at least two of the last five years before the sale. This is the standard residency requirement for the Section 121 exclusion, which allows you to exclude up to $250,000 in capital gains as a single filer or $500,000 as a married couple filing jointly.

For example, say you acquire a property through a 1031 exchange and rent it out for two years. You then move in and live there as your primary residence for two years. At that point you have owned the property for four years and met the rental and residency requirements, but you have not yet satisfied the five-year holding period. You would need to wait at least one more year before selling to qualify for the Section 121 exclusion.

Allocation of Gain

An update to the tax code applies to properties acquired after 2009. Specifically, the 121 exclusion shrinks according to how many years you rented out the property versus treating it as your primary residence. 

For example, say you buy a rental property in 2018 and rent it out for three years. Then, you convert the property to your primary residence. You live in the property for five years, resulting in a seven-year holding period in total (two years renting out plus five years as your primary residence). The two rental years create a long-term capital gains allocation in the following way: you’ll owe 2/7ths of the capital gains taxes you incur and can exclude 5/7ths from taxation. 

Leveraging Sections 1031 and 121 for Tax Advantages

Here’s an example to draw together the points about 1031 exchanges and Section 121 exclusions, along with their implications and requirements:

Rental Property Circumstances

Say you own a small piece of commercial real estate that you purchased for $200,000. Over the years you owned and rented it, you claimed $30,000 in depreciation deductions. That reduces your adjusted basis in the property to $170,000 ($200,000 purchase price minus $30,000 in depreciation).

The property is now valued at $300,000 but is not performing well, so you decide to sell. Your total profit on the sale is $130,000 ($300,000 sale price minus $170,000 adjusted basis). Of that $130,000, $30,000 is depreciation recapture and $100,000 is capital gain.

You take the proceeds and purchase a single-family real estate investment for $300,000. Because you acquired a similarly valued property, you use a 1031 exchange to defer the entire $130,000 in profit, including both the $100,000 capital gain and the $30,000 in depreciation recapture. No taxes are owed at the time of the exchange, but both amounts carry forward to the replacement property and will be due when you eventually sell without completing another exchange.

Tax Implications

Upon selling the property, the total gain is $430,000. Of that amount, $400,000 is long-term capital gains and $30,000 is depreciation recapture, which is treated as ordinary income.

Fortunately, you are eligible for a Section 121 exclusion on a portion of the capital gains. You lived in the home for five out of the nine years you owned it, so you can exclude 5/9ths, or roughly 55%, of the $400,000 capital gain. That comes to $220,000 in excluded gains, leaving $180,000 in taxable capital gains.

If your income places you in the 15% bracket for long-term capital gains, you would owe $27,000 on that portion ($180,000 x 0.15).

The $30,000 in depreciation recapture is handled separately. It is added to your taxable income for the year and taxed at your marginal tax bracket or 25%, whichever is larger. If the applicable rate is 25%, the tax on the recapture is $7,500 ($30,000 x 0.25). You do not owe the full $30,000 as a tax payment. You owe taxes on that amount at the applicable rate.

That brings the total estimated tax bill on the sale to $34,500: $27,000 in capital gains taxes plus $7,500 in depreciation recapture taxes.

Additional Considerations When Converting Rental Property to Primary Residence

Here are five common tips to help you successfully convert a rental property to a primary residence:

• No contingencies: When you acquire a property through a 1031 exchange, don’t agree to any contingencies about converting the property. You need to show consistent, indisputable proof that you intended to rent out the property when you purchased it. 
• Delay renovations: Similarly, only by performing renovations the property become habitable and up to code so you can rent it out. On the other hand, renovations matching your preferences, such as a remodeled bathroom or in-ground pool, can indicate that you planned to live in the property when you first purchased it as a rental. 
• Document rental activity: Keep clear records of the rental income you receive from the property. This documentation helps establish the property’s use as a rental for at least two years.
• Don’t discuss moving in: When you perform the 1031 exchange and rent out the property, keep your plans to turn the home into your primary residence to yourself. Again, the function of the property for the first two years you own it is solely to rent out. Otherwise, you jeopardize your ability to use a 121 exclusion down the road. 
• Ensure the rental unit’s validity: For the home to be a rental property, it must follow any applicable HOA codes, local rental laws and federal regulations. Failure to comply with these rules can demonstrate that you didn’t want to rent out the property and prevent you from receiving the 1031 and 121 tax benefits. 

Can I Change My Mind After a 1031 Exchange?

If you decide you no longer want to go through with the 1031 exchange, you can reverse the transaction. However, you may have to hold the property for a specific period before reversing it, and you will be liable for capital gains taxes on the original property’s sale. Additionally, any depreciation recapture that you deferred would become immediately due.

Therefore, it’s recommended to consult with a qualified tax advisor or attorney if you’re considering reversing a 1031 exchange. They can provide specific guidance based on your situation and help you understand the potential tax consequences.

Bottom Line

Converting a rental property into a primary residence involves careful planning and consideration of various tax implications. Section 121 of the IRS code and 1031 exchanges offer valuable tools to reduce the tax burden, but homeowners must follow specific rules around proof of intent to rent, rental period requirements and the five-year holding period. Missing any of these steps can disqualify the tax benefits entirely, so getting the details right before you sell matters as much as the strategy itself.

“Converting a rental property into a primary residence requires navigating complex sections of the tax code. However, if done properly, it could save you a significant amount of money in future taxes,” said Matthew Hofacre, CFP, EA.

Matthew Hofacre, Certified Financial Planner™ (CFP®), Enrolled Agent (EA), provided the quote used in this article. Please note that Matthew is not a participant in SmartAsset AMP, is not an employee of SmartAsset and has been compensated. The opinion voiced in the quote is for general information only and is not intended to provide specific advice or recommendations.

Tips for Converting a Rental Property to a Primary Residence

• Converting a rental property you purchased through a 1031 exchange is more likely to succeed if you create a detailed plan ahead of time. If you’re not sure where to start or need help outlining each step, a financial advisor can provide expertise on completing a 1031 exchange if you own an investment property. Finding one doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Converting rental property means turning the home into a residence. If you’re torn on how to invest your money, here’s a guide on deciding between commercial or residential real estate investments.

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