While the rest of the United States deals with fluctuating and volatile real estate markets, Oklahoma remains consistent. For real estate investors, this presents a potentially valuable opportunity. Experienced and beginner investors alike can buy investment property to grow the value of their portfolio.
However, buying and selling can come with a hefty capital gains tax. One option is to do a 1031 exchange. But can you 1031 a primary residence? The short answer is probably not, but there are exceptions.
To find out if your property qualifies, let's look at what a 1031 exchange is and the rules surrounding it.
A 1031 exchange lets real estate investors swap out one property for another while deferring capital gains taxes typically due at closing. Investors use this tax tool to upgrade their investments without paying capital gains taxes.
That way, you can grow your portfolio to add real estate with higher property value without paying taxes on the proceeds. If you use this investment strategy correctly, an investor only pays taxes once, and it is at a long-term capital gains rate.
A capital gains tax is what you pay when you make a profit as an investor. A short-term capital gains tax for investments held for a year or less exists. There is a long-term capital gains tax for investments held longer.
The tax rates differ for the two and will vary based on your income level. Generally, long-term capital gains taxes are lower than short-term. Because of this, it's financially savvy to hold investments for longer.
The IRS does not limit how frequently you do a 1031 exchange. You can roll over your gain from one property to the next repeatedly. However, there are rules to be aware of that can trip you up if you are not careful.
For example, specific rules exist on how to turn your principal residence into an investment property. To report your 1031 exchange to the IRS, you need to use Form 8824.
A traditional 1031 exchange takes place between two people, with them trading one property for another. However, it can be challenging to find someone with a property similar to yours who also wants to trade. This is when timelines come into play.
To do a delayed exchange, you will work with a third party who works as a middleman. The first timeline to stay aware of is the 45-day rule. Once you sell the property, the proceeds go to the intermediary to hold.
You have 45 days from this sale to designate your replacement property. You can designate up to three properties but must close on at least one. They must qualify with a valuation test if you want to designate more than three.
The second deadline to meet is the 180-day rule. After selling the old property, you have 180 days to close on the new property. These timelines can get challenging, so it's helpful to have a guide to walk you through the process as a beginner.
A reverse exchange is when you buy the replacement property before you sell your current investment property. The same 45 and 180-day rules apply. You would transfer the new property to an exchange titleholder.
Then, identify your property within 45 days and complete the transaction within 180 days.
The short answer is no; you cannot 1031 exchange your primary residence. This is because you live in the home, and it is not an investment property. However, you can turn your primary residence into an investment property.
You would need to move out of the property and discontinue using it as a residence. Then, rent it out to someone at fair market value for a reasonable amount of time. There is no specific amount of time required defined in the tax code.
However, renting the property for at least two years is advisable. This will convert the property from a primary residence to an investment property.
When doing a 1031 exchange under Section 121, you can exclude tax liability of $250,000 as a single filer or $500,000 when married and filing jointly.
The IRS includes a primary residence exclusion under Section 121. Under this exception, you can use part of the property as your primary residence and another part of the property for investment.
For example, if you own farmland with investment land and your primary home. Or perhaps you own a multi-family property with multiple residences and live in one of them.
Unlike general 1031 exchanges, you can only do a Section 121 exchange once every two years. This is because you must have lived in the home as your primary residence for at least two of the last five years before the exchange. It would be impossible to satisfy this requirement and do a Section 121 exchange more often than once every two years.
Alternatively, you may decide to turn your investment property into your primary residence. You need to wait, as you can't immediately convert the property. For the property to qualify, you need to meet specific requirements.
You must rent the house to someone else in the two 12-month periods following the exchange. It must be at fair market value and longer than 14 days. Your personal use cannot be more than 14 days or 10% of the days the house is rented at fair market value.
You must wait five years after making the switch for the property to qualify for the $500,000 exclusion exemption.
So, can you 1031 a primary residence? Yes, but there are some rules you need to follow to do it successfully. You cannot simply exchange your primary residence.
Working with experienced real estate investors can provide much-needed guidance for beginners. The Virtual Real Estate Team works with individuals looking to use real estate investing to get out of debt and grow their wealth. We educate investors on maximizing their investments while minimizing their tax liabilities.
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Joe Pryor is a professional real estate investor and has been helping new investors find profitable residential properties for over 30 years. He created The Virtual Real Estate Team to help teach new investors how to get started investing in real estate. He loves teaching and has a growing YouTube channel where he creates new training videos regularly.