In essence, 1031 Exchange arising from Internal Revenue Code section 1031 allows investors to defer their capital gains tax payment. To put into context, the long-term capital gains tax rate in 2020 is 15% for the bracket between $53,601 and $469,050, and 20% for $460,050 or more. Hence, the 1031 Exchange is a lucrative tool for investors to maximize their capitals, jumping from one property investment to another. Because the ultimate goal of the 1031 Exchange is to incentivize investments, there is a general ban on deploying the proceedings from a sale of business property in exchange for the investor’s primary residence, no matter how luxurious it is. It is considered for personal necessity or pleasure with no commercial or business intention. The bottom line is that properties involved in the Exchange must be bought and sold for investment or business purposes only. However, the actual wording of the law does open a backdoor for a possibility that an investor could convert a 1031 Exchanged property for commercial purposes to a primary residence in the long run. As a result, an investor could obtain his or her primary residence without ever paying capital gains tax for the sale of the exchanged commercial property.
As noted above, although the 1031 Exchange prohibits swapping an investment property with a primary home, it does not require that the traded property for business purposes could never be converted to a primary residence. Now the question arises as to how such a converted primary residence would be taxed when it is sold. The answer is in Internal Revenue Code (IRC) §121. The law provides several rules as the qualifications to exclude financial gains from the sale of a principal residence. The basic rule is that during the 5 year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more. If the rule is met, the amount of gain with respect to any sale or exchange under $250,000 would be excluded from gross income. For certain joint returns, the limited amount would increase to $500,000 instead of $250,000 if the following conditions are satisfied: 1) either spouse meets the 2-year ownership requirements aforementioned; 2) both spouses meet the 2-year use requirements aforementioned. It is critical to note that the application mentioned above is constrained to only 1 sale or exchange every 2 years. In other words, the basic rule does not apply to any sale or exchange by the taxpayer if during the 2 year period ending on the date of such sale or exchange, there was any other sale or exchange by the taxpayer to which also could be covered by the basic rule.
The law also makes several further exclusion rules regarding the gain allocated to nonqualified use. These rules are logical in the sense that the tax benefit from the basic rule above should not cover the gain from the sale or exchange of property as it is allocated to periods of nonqualified use. The “period of nonqualified use” means any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse. To calculate the percentage of nonqualified usage, the equation is the ratio that the aggregate periods of nonqualified usage during the period such property was owned by the taxpayer bears to the period such property was owned by the taxpayer. For example, if the taxpayer or investor A owned Property X for 5 years, but he only used it as his or her principal residence for 3 years. The allocated gain to periods of nonqualified use is, therefore, 40%. The key concepts here are the period of usage and ownership. Basically, Investor A must be the owner of Property X the entire time. When investor A sold Property X at the end of Year 5. The gain excluded was only for those 3 years that not only he used the property but also it had been his principal residence. To make things a bit more complex, the law stipulates several exceptions that “period of nonqualified use” does not include. One of them is that any portion of the 5-year described in the basic rule, which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer’s spouse. For example, within a 5 year ownership of Property Y, taxpayer B rented it out for 1 year, then used it for 2 years, then rented it out again for 1 year. Finally, after using it for another year as her principal residence, she decided to sell the property. In this case, only the first 1 year would be counted in the period of nonqualified use.
Lastly, the law provides limited qualifications for certain circumstances. It states that even the basic rule would not apply by reasons of a failure to meet the ownership and use requirements or applied more than 1 sale or exchange every 2 years, if such sale or exchange by reason of a change in place of employment, health, or to the extent provided in regulations, unforeseen circumstances, the gain from the sale of principal residence could still be excluded. The detailed calculation formula is relatively the same as the ratio calculation mentioned above but not identical. However, since it is not the primary focus of this article, no more ink would be poured out here.
In sum, if one may call it, it is a “loophole” that could convert a commercial property, such as rental properties, into the investor’s primary residence. As the law currently stands, in the case that Investor A purchased a commercial Property X through the 1031 Exchange by deferring his or her capital gains tax, Property X could later be converted to Investor A’s primary residence and gain tax could be avoided at the time of sale of Property X, so long as the basic rule is satisfied. Of course, for the purpose of 1031 Exchange, Property X must be used for business purpose for a period of time, rather than being converted to a primary residence immediately after the Exchange.