How to Convert Rental Property to a Primary Residence

Converting a rental property into a primary residence is a significant financial move. It carries potential tax implications that necessitate careful use of tools like Section 121 of the IRS code. However, understanding the intricacies of these laws is crucial. Here’s how to convert a rental property into a primary residence the right way.

A financial advisor can help optimize your real estate portfolio to lower your tax liability.

How to Convert Rental Property to a Primary Residence

Converting a rental property into a primary residence can have unwanted tax implications if you go in unprepared. Fortunately, tax exemptions are available through Section 121 of the IRS code and 1031 exchanges. Depending on the situation, you can apply one or both of these tools to minimize your tax liability. Here are how these two tools work:

1. Section 121 Exclusion

Section 121 of the Internal Revenue Code exempts up to $250,000 (or $500,000 for a married couple filing jointly) of capital gains from the sale of a primary residence. To qualify, it needs to have been your primary residence for at least two years of the previous five years. ¹ While a 1031 exchange affects this exclusion, they can work together to create a tax advantage.

2. 1031 Exchange

A 1031 exchange, also known as a like-kind exchange, allows you to delay capital gains taxes. You can defer these taxes every time you sell an investment property by acquiring other investment properties of like kind.

The process runs on strict deadlines. Once the sale closes, you have 45 days to identify potential replacement properties. You can name a single property at the same price, or multiple properties. Those properties must have a combined value of 200% or less of what you sold. From there, you have 180 days from the original sale to close on the replacement. A qualified intermediary usually must hold the sale proceeds during this window. If the seller takes possession of the funds at any point during the transaction, the exchange may be disqualified. If it does, the deferred taxes become due. ²

Tax Implications and Limitations

Section 121 exclusions and 1031 exchanges are complex financial moves. Homeowners must follow numerous rules to avoid penalties. Here’s what to remember: 

Proof of Intent to Rent

The IRS pays close attention to intent when you convert a rental property acquired through a 1031 exchange. The IRS wants to determine if you performed the exchange just to turn the replacement property into your personal home. If the IRS decides you never wanted to hold it as an investment, it won’t allow the exchange to occur. If that happens, the deferred taxes become due immediately.

To protect the exchange, document your genuine intent to use the property as a rental. Keep any signed rental agreements with tenants or copies of public listings advertising the property for rent. You’ll also need financial records showing rental income collected. The stronger your paper trail showing actual rental activity, the better. Without that documentation, you risk losing the tax deferral the exchange was designed to provide.

Initial Rental Unit Use and Subsequent Residency Length

If you acquire a dwelling as replacement property in a 1031 exchange, review the IRS safe-harbor guidance. It can help you establish that you held the property for investment before later personal use. Under that safe harbor, the taxpayer generally must own the property for at least 24 months after the exchange. During each 12-month period, they must rent the property at a fair rate for at least 14 days. Also, the taxpayer’s personal use generally cannot exceed the greater of 14 days or 10% of the rental days.

After this period expires, you can move into the property and make it your home. Then, to qualify for a Section 121 exclusion, you must treat the property as your primary residence for at least two years out of the five years that precede selling the home.

Single Ownership

The Section 121 exclusion is available to individuals or married couples filing jointly. This tax break is unavailable if a company, group, or business partnership owns the property. 

Depreciation Recapture

Owning a rental property allows you to deduct a portion of the property’s value each year through depreciation. When you later sell the property at a gain, the Section 121 exclusion generally cannot shelter the portion of gain attributable to depreciation deductions allowed or allowable for rental or business use after May 6, 1997. For depreciable real property held more than one year, the IRS generally treats this gain as unrecaptured Section 1250 gain and taxes it at a maximum federal rate of 25%. ³

For example, if you claimed $50,000 in depreciation deductions over the years you rented the property and at least $50,000 of gain is attributable to that depreciation, as much as $50,000 may remain taxable even if other gain qualifies for the Section 121 exclusion. At a 25% federal rate, the tax on that portion would be $12,500, although the actual rate can be lower depending on your taxable income.

Five-Year Holding Period for Section 121

Converting a 1031 exchange property into a primary residence and then selling it under the Section 121 exclusion requires meeting additional requirements.

If you acquired the home in a 1031 exchange, Section 121 generally cannot exclude gain from a sale that occurs during the five-year period beginning on the date you acquired the property.

You also must satisfy the Section 121 ownership and residence requirements. Generally, this means owning the home for at least two years and using it as your main home for at least two years during the five-year period ending on the sale date.

For example, say you acquire a property through a 1031 exchange and rent it out for two years. You then move in and live there as your primary residence for two years. At that point you have owned the property for four years and met the rental and residency requirements, but you have not yet satisfied the five-year holding period. You would need to wait at least one more year before selling to qualify for the Section 121 exclusion.

Allocation of Gain

Converting a former rental into your main home does not necessarily make all appreciation eligible for the Section 121 exclusion. For periods after 2008, gain allocated to certain periods when the property was not used as your principal residence generally cannot be excluded. The calculation compares applicable periods of nonqualified use with the total period the property was owned. Certain periods are excluded from the definition of nonqualified use.

For example, assume you buy a property on Jan. 1, 2020, rent it for three years and then use it as your main home for the next five years before selling it at the end of 2027. Ignoring depreciation and assuming the three rental years are nonqualified use, 3/8 of the gain would generally be allocated to nonqualified use and would not qualify for the Section 121 exclusion. The remaining gain could potentially qualify, subject to the exclusion limit and other Section 121 requirements.

Leveraging Sections 1031 and 121 for Tax Advantages

Here’s an example to draw together the points about 1031 exchanges and Section 121 exclusions, along with their implications and requirements:

Rental Property Circumstances

Say you own a small piece of commercial real estate that you purchased for $200,000. Over the years you owned and rented it, you claimed $30,000 in depreciation deductions. That reduces your adjusted basis in the property to $170,000 ($200,000 purchase price minus $30,000 in depreciation).

The property is now valued at $300,000 but is not performing well, so you decide to sell. Your total profit on the sale is $130,000 ($300,000 sale price minus $170,000 adjusted basis). Of that $130,000, $30,000 is depreciation recapture and $100,000 is capital gain.

You take the proceeds and purchase a single-family real estate investment for $300,000. Because you acquired a similarly valued property, you use a 1031 exchange to defer the entire $130,000 in profit, including both the $100,000 capital gain and the $30,000 in depreciation recapture. You don’t owe taxes at the time of the exchange, but both amounts carry forward to the replacement property and will be due when you eventually sell without completing another exchange.

Tax Implications

Assume the replacement property is later sold after the applicable holding and residence requirements have been met. The tax calculation would have to account for the property’s adjusted basis, the gain deferred from the earlier 1031 exchange, depreciation and any gain allocated to periods of nonqualified use.

Section 121 does not automatically exclude all of the remaining gain simply because the owner later lived in the replacement property. Gain attributable to nonqualified use can remain taxable, and gain attributable to depreciation allowed or allowable after May 6, 1997, cannot be excluded under Section 121.

As a result, the eventual tax liability depends on the complete ownership and use history rather than only the number of years the replacement property served as a primary residence.

What to Do When You Move Into a Former Rental

The tax conversion begins with a change in how you actually use the property, but there are several practical steps to take when the rental becomes your home. End any tenant arrangement according to the lease and applicable state or local law, and keep records showing the date the property stopped being available for rent and the date you began using it as your main home.

That change also affects rental deductions. Expenses attributable to the period when the property was held for rental use may be deductible under the rental-property rules, while personal expenses incurred after the conversion generally are not rental deductions. Depreciation on the building also stops when the property is converted from an income-producing use to personal use. Records of depreciation claimed or allowable during the rental period should be retained because those amounts can affect adjusted basis and the taxable gain when the home is eventually sold.

If a future Section 121 exclusion is part of the plan, keep evidence of when the property became your main home. Documents such as utility bills, insurance records, a driver’s license, voter registration and tax filings can help establish residence. The conversion date is particularly important because living in the property for two years does not by itself make all of the eventual gain tax-free. Earlier nonqualified use and rental depreciation can still leave part of the gain taxable.

Additional Considerations When Converting Rental Property to Primary Residence

Here are five common tips to help you successfully convert a rental property to a primary residence:

• No contingencies: When you acquire a property through a 1031 exchange, don’t agree to any contingencies about converting the property. You need to show consistent, indisputable proof that you intended to rent out the property when you purchased it. 
• Delay renovations: Similarly, only perform renovations to get the property habitable and up to code so you can rent it. Renovations matching your preferences, such as a remodeled bathroom or pool, can indicate you planned to live there all along. 
• Document rental activity: Keep clear records of the rental income you receive from the property. This documentation helps establish the property’s use as a rental for at least two years.
• Don’t discuss moving in: When you perform the 1031 exchange and rent out the property, don’t share that you plan to live there eventually. Again, the function of the property for the first two years you own it is solely to rent out. Otherwise, you jeopardize your ability to use a 121 exclusion down the road. 
• Ensure the rental unit’s validity: For the home to be a rental property, it must follow the rules. This includes any applicable HOA codes, local rental laws and federal regulations. Failure to comply with these rules can demonstrate that you didn’t want to rent out the property. This would prevent you from receiving the 1031 and 121 tax benefits. 

Can I Change My Mind After a 1031 Exchange?

If you decide you no longer want to go through with it, you can reverse the 1031 exchange. However, you may have to hold the property for a specific period before reversing it, and you will be liable for capital gains taxes on the original property’s sale. Additionally, any depreciation recapture that you deferred would become immediately due.

A qualified financial advisor or tax attorney can be a valuable resource if you want to do a 1031 exchange. They can provide specific guidance based on your situation and help you understand the potential tax consequences.

Bottom Line

Converting a rental property into a primary residence involves careful planning and consideration of various tax implications. Section 121 of the IRS code and 1031 exchanges offer valuable tools to reduce the tax burden. However, homeowners must follow specific rules around proof of intent to rent, rental period requirements, and the five-year holding period. Missing any of these steps can disqualify the tax benefits entirely. Getting the details right before you sell matters as much as the strategy itself.

Tips for Converting a Rental Property to a Primary Residence

• Converting a rental property you purchased through a 1031 exchange is more likely to succeed if you create a detailed plan ahead of time. If you’re not sure where to start or need help outlining each step, a financial advisor can provide expertise on completing a 1031 exchange if you own an investment property. Finding one doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Converting rental property means turning the home into a residence. If you’re torn on how to invest your money, here’s a guide on deciding between commercial or residential real estate investments.

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