What is the 1031 Exchange 5-Year Rule?
What is the 1031 Exchange 5-Year Rule?
In general conversation, people often refer to the “5-year rule” in the context of a 1031 exchange when talking about converting an investment property (originally acquired via a 1031 exchange) into a primary residence—and then selling it while trying to claim the homeowner capital-gains exclusion.
Here’s the background:
- 1031 Exchange Basics
- A 1031 exchange (named after IRC Section 1031) allows you to defer capital gains taxes when you sell an investment or business-use property and reinvest the proceeds in a “like-kind” property.
- By deferring these taxes, you essentially roll over the gains from one property to the next.
- The Principal Residence Exclusion
- When you sell your primary residence, you may be able to exclude up to $250,000 of capital gains ($500,000 for married couples filing jointly) from taxes, provided you meet the requirements of Section 121 of the tax code.
- The main requirements for the Section 121 exclusion are typically that you owned and used the home as your principal residence for at least 2 out of the last 5 years prior to the sale.
- The “5-Year Rule” After a 1031 Exchange
- If you acquire a property through a 1031 exchange and later convert it to your principal residence, you cannot immediately sell it and claim the full Section 121 exclusion.
- Under the Housing Assistance Tax Act of 2008, you must own the converted property for at least 5 years from the date of the 1031 exchange before you are eligible to use the Section 121 homeowner exclusion upon sale.
- Why This Rule Exists
- This rule was designed to prevent investors from “flipping” a newly exchanged property into a principal residence to quickly claim the homeowner capital-gains exclusion.
- It ensures that the property truly is used for a legitimate period as an investment or as a primary residence (depending on the situation) before reaping the tax benefits.
- How It Works in Practice
- Suppose you perform a 1031 exchange on an investment property, and six months later, you decide to move into the new property. You convert the property to your personal residence.
- Before you can sell this property and claim the homeowner exclusion (up to $250,000/$500,000), you must wait at least 5 years from the date of acquisition in the exchange.
- Even after waiting 5 years, you still need to meet the standard Section 121 requirements:
- You lived in the property as your primary residence for at least 2 out of the last 5 years before selling.
- Also be aware that some of the gain might still be subject to depreciation recapture or allocation of “non-qualified use” (especially if it was used as an investment for a portion of that time).
Key Takeaways
- The “5-year rule” specifically addresses how soon you can use the homeowner exclusion (Section 121) for a property you received via a 1031 exchange and then converted into a primary residence.
- You must own that property for at least 5 years from the date of the exchange before using the homeowner exclusion.
- You still must meet the usual requirements for the principal residence exclusion (owning and living in it for at least 2 of the last 5 years).
- Part of your gain can still be taxable if it includes depreciation recapture or if there was “non-qualified use.”
