Can Property Resulting from a 1031 Exchange Be Put to Personal Use?

by Loella Haskew, CPA 

My wife and I have a rental cottage we acquired two years ago under a 1031 exchange. We would now like to either make it our principal residence or, even better, sell the place and use the money to build a new house. Would we have to pay capital gain tax in either situation?

Before I answer the question, let’s review the purpose of IRS Code Section 1031.

The law recognizes that businesses sometimes hold property (real estate, tangible personal property, or investments) that no longer serves its original purpose. An example is a factory that outgrows its facilities. The owners would suffer financially if they had to sell the facilities, pay tax on a substantial gain, and then try to invest the remaining funds into new facilities. Most likely they would not have enough money to purchase or build the facilities they needed. Therefore, the chances that they would sell the old facilities and rebuild are reduced. That could mean that the business eventually would fold, leaving its workers unemployed. Clearly that’s not good for the economy.

So Congress revised the IRS codes to permit “like kind” exchanges. Section 1031 says, “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” Both at the beginning and end of the transaction, the properties involved must serve a business or investment purpose and must be similar in nature.

In our factory scenario, the owners would meet 1031 criteria if they traded the old property for like property elsewhere. Similarly, people who own rental property could trade it for similar rental property. In both scenarios, any potential capital gain tax is deferred. The owners will have to pay capital gain tax once they sell the property resulting from a 1031 exchange and realize any profit on it, however.

Incidentally, you can use a 1031 to “trade up.” For example, you may have property worth $250,000 but would rather have similar property that is valued at $400,000. You can do a 1031 exchange and pay the other party $150,000. The other party, however, would have to pay capital gain tax if such an exchange resulted in a profit for him or her.

It is possible to eventually convert property involved in a 1031 exchange to personal use and not have to immediately pay capital gain tax. Unfortunately, the IRS code doesn’t specifically state how long the property must be held for productive use or investment before such a conversion.

If you convert property to personal use, you must prove that your intent at the time of the exchange was for a business purpose. Otherwise, you will have to pay capital gain tax on the original transaction. The longer you hold the new property before the conversion, the better. The more time between the exchange and the conversion, the more likely the IRS will regard the original transaction as a business one, not a personal one.

Even so, once such a conversion occurs, any gain deferred in the exchange will reduce the property’s cost basis. You also will have to pay tax on any depreciation should you sell the property regardless of how much gain you can exclude under the capital gain rules for principal residences.

For example, let’s say that you have rental property involved in a 1031 exchange 10 years ago. At the time, the property had an assessed value of $200,000. Because of various market conditions, you can no longer rent it. You and your wife, however, decide that the property would be an ideal residence and move in. Three years later you sell the house for $500,000.

In this example, you would make $300,000 in profit. (For simplicity’s sake, I am not subtracting commission and other fees that would reduce the profit.) Normally, you would not have to pay capital gain tax on that amount. The law says that a married couple does not have to pay tax on the first $500,000 in profit from the sale of a principal residence in which they have lived for two out of five years. But if you took $50,000 in depreciation over the 10 years you rented the property, you would have to pay tax on that $50,000 regardless.

As for selling the rental property and then using the cash to build a personal residence, that’s up to you. But such a sale will trigger capital gain and depreciation recapture tax on your profits. Since the original property was not your principal residence, you could not exclude any portion of the amount from the capital gain tax.

You should not base your decision on what to do with your property solely on its 1031 status. You should also consider other factors, including your lifestyle and other investments. And I recommend that you consult with a financial adviser, such as a CPA. He or she can provide an objective opinion and counsel you regarding your specific tax obligations.

Loella Haskew is a Lafayette, Calif., CPA with the firm of Buckley Patchen Riemann & Hall. You can reach her at (925) 284-5262.

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