Renting A Bedroom: Is A 1031 Exchange Possible?

A 1031 exchange is a swap of one real estate investment property for another, allowing capital gains taxes to be deferred. The IRS does not allow a primary residence to qualify for a 1031 exchange as it does not meet the 'held for productive use in a trade or business or for investment' requirement. However, there are certain conditions under which a primary residence can be converted into a rental property and then qualify for a 1031 exchange. For example, if you own a duplex, you can rent out one unit at fair market value and sell the duplex, allowing you to use both the primary residence exclusion and the 1031 exchange deferral.

Can I rent out a bedroom in my primary residence and use a 1031 exchange?

A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred. It is a tax break that allows investors to sell a property held for business or investment purposes and swap it for a new one purchased for the same purpose, allowing them to defer capital gains tax on the sale. The properties being exchanged must be considered ""like-kind" in the eyes of the IRS for capital gains taxes to be deferred.

According to IRS guidelines, a primary residence does not meet the "held for productive use in trade or business or for investment" requirement stipulated by IRC Section 1031. Therefore, a primary residence typically does not qualify for 1031 treatment. However, there are certain exceptions and complexities that should be noted.

If you rent out a bedroom in your primary residence and meet specific conditions, you may be able to include it in a 1031 exchange. Here are some key considerations:

• Rental Period: To qualify for a 1031 exchange, your primary residence would need to be transitioned into an investment property. This can be achieved by renting out the property for a reasonable period, typically a minimum of two years. During this time, you should refrain from living in the property yourself.
• Fair Market Value: Ensure that you are renting out the bedroom at a fair market rate. This is an important criterion for the IRS to consider the property as a bona fide investment property.
• Live Elsewhere: While renting out a portion of your primary residence, you should live elsewhere to reinforce the change in the property's use.
• Multi-Unit Property: If you own a multi-unit property, such as a duplex, and rent out one unit while occupying the other, you may be able to include the rented unit in a 1031 exchange. The unit you occupy would qualify for the primary residence exclusion, while the rented unit could be considered for the 1031 exchange.
• Time Requirements: Keep in mind the time requirements for a 1031 exchange. You must identify the replacement property within 45 days of selling the old property, and the entire exchange process must be completed within 180 days.
• Professional Guidance: Consulting a qualified professional, such as a CPA or a tax advisor, is highly recommended due to the complexities involved in 1031 exchanges.

In summary, while it is generally not possible to include your primary residence in a 1031 exchange, renting out a bedroom and meeting specific conditions can potentially allow you to utilize this tax strategy. However, it is important to carefully review the IRS guidelines, seek professional advice, and ensure that you understand the requirements and complexities involved.

What are the requirements for a 1031 exchange?

To qualify for a 1031 exchange, the property must be used for investment or business purposes. The Internal Revenue Code (IRC) outlines specific steps that investors must follow to qualify for a 1031 exchange.

Like-Kind Properties

The properties being exchanged must be considered "like-kind" in the eyes of the Internal Revenue Service (IRS) for capital gains taxes to be deferred. "Like-kind" refers to the nature of the investment rather than the form. Any type of investment property can be exchanged for any other type of investment property. For example, a single-family home can be exchanged for a triplex, duplex, raw land, or a commercial rental property.

Location

Both properties must be located in the United States to qualify for a 1031 exchange.

Timing

There are two key timing rules that must be observed in a delayed exchange. Firstly, within 45 days of the sale of the property, the seller must designate the replacement property in writing to the intermediary, specifying the property they want to acquire. Secondly, the seller must close on the new property within 180 days of the sale of the old property. These two time periods run concurrently, meaning the seller has 45 days to find the property and 135 days to close.

Value

The replacement property should be of equal or greater value than the property being sold.

Intermediary

A qualified intermediary is required to hold the proceeds from the sale of the original property in escrow. The intermediary cannot be someone who has previously acted as the seller's agent.

Form 8824

The IRS must be notified of the 1031 exchange by compiling and submitting Form 8824 with the seller's tax return in the year the exchange occurred.

What are the time limits for a 1031 exchange?

The 1031 exchange process has two key time limits that must be strictly followed to qualify for tax deferral. Firstly, within 45 days of selling your original property, you must identify the replacement property that you want to acquire. The IRS allows you to designate up to three potential replacement properties, as long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.

Secondly, you must close on the new property within 180 days of selling the old one. These two time periods run concurrently, so if you designate a replacement property exactly 45 days after selling the original, you will have 135 days left to close on the new one.

It is important to note that these time limits cannot be extended, even if the 45th or 180th day falls on a weekend or a legal holiday. However, the IRS may grant an extension in certain circumstances, such as for taxpayers affected by federally declared disasters or military actions.

Can I exchange a primary residence for a vacation home?

A 1031 exchange is a swap of one real estate investment property for another, allowing capital gains taxes to be deferred. The term gets its name from Section 1031 of the Internal Revenue Code (IRC). While a primary residence does not meet the "held for productive use in a trade or business or for investment" requirement stipulated by IRC Section 1031, there are certain conditions under which a primary residence can be included in a 1031 exchange.

Converting a Primary Residence into an Investment Property

One way to include a primary residence in a 1031 exchange is to transition it into an investment property before selling it. This can be achieved by living elsewhere and renting out the former residence for at least two years. If you own a duplex, you can live in one unit and rent out the other at fair market value. In this case, the unit you occupy qualifies for the exclusion, while the sale price allocated to the rented unit can be used in a 1031 exchange.

Rules for Including a Vacation Home in a 1031 Exchange

A vacation home can be included in a 1031 exchange if it is converted into an investment property. This can be done by renting out the property for at least 14 days in each of the two 12-month periods immediately before the exchange. Additionally, personal use of the property should not exceed 14 days or 10% of the number of days it was rented out during the same period. These requirements also apply to a property acquired through a 1031 exchange if it is to be used as a vacation home.

Rules for Converting a 1031 Exchange Property to a Primary Residence

If you intend to convert a property acquired through a 1031 exchange into your primary residence, you must ensure that your initial intention was to hold the property as an investment or for use in a business. Additionally, you must own the property for at least two years before the sale and rent it out for at least 14 days in each of those two years. Personal use of the property should be limited to no more than 14 days per year or less than 10% of the days it was rented out.

Important Considerations

When converting a 1031 exchange property into a primary residence, it is essential to avoid creating a contingency in the exchange agreement that states your intention to do so. It is also advisable to refrain from starting any construction or renovation immediately after the exchange and to delay making specific plans or architectural drawings until after the required holding period.

What are the benefits of a 1031 exchange?

A 1031 exchange is a tax-saving strategy that allows investors to swap one investment property for another without paying capital gains tax on the sale. Here are some benefits of a 1031 exchange:

Defer Capital Gains Tax

The primary benefit of a 1031 exchange is the ability to defer capital gains taxes. While it is only a delay in paying taxes, investors can, in theory, keep using multiple exchanges to postpone taxes indefinitely. This allows investors to grow their wealth faster as they can reinvest the full amount from the sale of the previous property.

Exposure to New Markets

The 1031 exchange allows investors to quickly unload current real estate investments and gain exposure to new markets with higher returns. This is especially beneficial when certain real estate markets experience surges, as investors can capitalise on these opportunities without paying capital gains taxes at the time of the sale.

Defer Taxes Until Death

There is a saying among real estate investors: "swap until you drop". With a 1031 exchange, investors can keep deferring capital gains taxes until they die. Additionally, they can leave the properties to their heirs, who will inherit them at the current fair-market price, with all accumulated capital gains taxes eliminated.

Increase Equity and Diversify Portfolio

A 1031 exchange is a great way to increase equity and diversify an investment portfolio. Investors can trade up to a higher-value property or multiple properties without paying taxes on the new investment. This enables investors to access higher-value properties more easily and grow or reinvent their real estate portfolios to suit their interests.

Reset Depreciation Schedule

Conducting a 1031 exchange resets the depreciation schedule, which is the length of time over which deductions are taken to account for wear and tear on the property. This can result in bigger tax benefits each year.

While a 1031 exchange offers these benefits, it is important to note that there are also some risks and complexities involved, including strict timelines, complex tax documentation, and the responsibility to choose an experienced qualified intermediary to facilitate the exchange.

Frequently asked questions