How to Use a 1031 Exchange for Rental Property Conversion | DST Investment

If you are looking to convert a rental property into your primary residence, you may be familiar with a 1031 exchange. This article will break down how a 1031 exchange works and the benefits of converting your rental property into a primary home with a 1031 Exchange.

What is a 1031 Exchange?

A 1031 exchange (named for Section 1031 of the IRS internal revenue code) allows investors to defer capital gains taxes if they sell one investment property and use the proceeds to purchase another qualifying investment property within 180 days.

For example, let’s say you own an apartment building that has appreciated in value since you purchased it. You decide that it’s time to move on from this investment by selling it and using the proceeds to buy an even bigger multifamily building. However, real estate prices are coming down due to demand slowing down because interest rates are rising, so you expect to take a loss.

If you were to sell the property and then buy a new one, you would have to pay capital gains taxes on that amount. This is why a 1031 exchange works so well. If you work with an experienced real estate intermediary who either holds the money until it’s ready to be used for your next purchase or disburses them within 180 days of receipt, you don’t have to worry about paying capital gains tax on any losses from selling your old rental property!

The capital gains tax exclusion for primary residences

Many people choose to use a 1031 exchange when changing to a primary residence because the capital gains tax rates for investment property are typically much higher than those on your primary residence.

For example, if you had $500,000 in taxable income that was all from investments and you paid 15% long-term capital gains taxes (that’s just 5% more than the highest rate of federal income tax), you would expect to pay about $75,000 in taxes without a 1031 exchange. However, with a 1031 exchange, this bill shrinks down to around $30,000 — meaning you can save over $45,000!

In order to qualify for this tax exclusion, you must have owned the property for at least two years. Also, if you are thinking of downsizing your home to use a 1031 Exchange to turn your primary residence into an investment property, keep in mind that you can’t claim the capital gains exclusion on another primary residence for at least two years after selling it. However, there is no time limit between when you sell one rental property and purchase another.

What If I Have More Than One Rental Property?

You may be wondering about how these rules work if you own more than one rental property. First of all, if any one of the properties has been occupied as a personal residence within the last two years, none of them qualify for a 1031 exchange.

Next, you can’t use the funds from one rental property to buy the next–you must sell all of your properties in order to do that. Once you have sold your properties and received the funds, only then can you start your search for a new investment property.

Essential Tips for Using a 1031 Exchange

Before you begin the process of turning your property into a primary residence, here are some important things to keep in mind:

  • The capital gains tax rates for investment property are typically much higher than the rates on your primary residence. That is why you should consider using a 1031 exchange!
  • You cannot use any funds from one rental property to buy the next; instead, you must sell each property and then use those proceeds to purchase a new one.
  • If you have owned more than one rental property within the last two years, none of them qualify for a 1031 exchange unless they were all used as personal residences. However, there is no time limit between when you sell one rental property and purchase another, so if you already own multiple rental properties and want to use a 1031 exchange, wait until you sell one before starting your search for another.
  • If you have converted your property into a primary residence and the tax exemption is not yet complete, it’s important to note that you can’t simply move back in and expect the process to start over. Instead, you will have to wait until the entire process is finalized and then start living in your property as a primary residence again.

While it’s not possible for everyone to swap their rental home for a primary residence, 1031 exchanges can benefit those who need or want to do so! For more information on this topic and others related to real estate investing, visit our webpage or contact us directly, and we can provide assistance.