Can I Do a 1031 Exchange on My Home?

The short answer: a purely personal residence cannot be exchanged under Section 1031. A 1031 exchange applies only to real property held for investment or business use. But in New York, many homes are not purely personal: a two-family with the owner upstairs and a tenant downstairs, an apartment that was once your home and is now rented, a vacation house you use now and then. In these situations, a 1031 exchange can often be combined with the home sale exclusion.

First, the Home Sale Exclusion: Section 121

When you sell your principal residence, if you owned and lived in it for at least two of the five years before the sale, you may exclude up to $250,000 of gain if single, or $500,000 if married filing jointly (Internal Revenue Code Section 121). New York State and City income taxes generally follow.

A pure home uses Section 121; a pure investment uses Section 1031; a mix of both can use a combination.

Situation One: You Live on One Floor and Rent the Others

This is classic New York, such as a two- or three-family house in Queens or Brooklyn. IRS guidance (Rev. Proc. 2005-14) allows:

• The owner-occupied portion to qualify for the Section 121 exclusion;
• The rental portion to be exchanged under Section 1031.

A simplified example: A married couple owns a two-family house, living upstairs and renting downstairs, with floors of equal size. They sell for $1.6 million. Their adjusted basis is $600,000, for a gain of $1 million.

This example ignores selling costs and depreciation recapture. Depreciation on the rental portion cannot be excluded under Section 121 but can be deferred through a 1031 exchange. Have your accountant determine the actual allocation and tax.

Situation Two: A Former Home Now Rented Out

After you move out and rent the home for a period, it can become investment property eligible for a 1031 exchange. Better still:

• If you sell within three years of moving out, you still meet the “two of the last five years” test and can first exclude up to $250,000 / $500,000 of gain under Section 121;
• The remaining gain can then be deferred under Section 1031;
• Under IRS guidance, cash you take out up to the amount of the Section 121 exclusion generally is not treated as taxable “boot.”

How long must it be rented? The law sets no specific period. A common practical recommendation is at least a year, at market rent, with leases, rent records and tax returns to show for it.

Situation Three: A Vacation or Second Home

A vacation home used mainly by you does not qualify. The IRS offers a safe harbor (Rev. Proc. 2008-16) under which a dwelling is treated as investment property if:

• You own it for at least 24 months before (or after) the exchange;
• In each of the two 12-month periods, you rent it at fair market rent for at least 14 days;
• In each 12-month period, your personal use does not exceed the greater of 14 days or 10% of the days rented.

Situation Four: You Later Want to Live in the Replacement Property

You can, but be careful:

• The replacement must at first be genuinely held for rental or investment. If you move in right after buying it, the IRS may conclude you bought it as a home all along, and the whole exchange may fail;
• If you later convert it to your residence and want the Section 121 exclusion, you must have owned it for at least five years after acquiring it (Section 121(d)(10));
• Periods after 2008 when it was not your residence also reduce the excludable gain proportionally.

Situation Five: Store Downstairs, Home Upstairs

In New York’s common mixed-use buildings, the commercial and rental portions can be exchanged under Section 1031 and the owner-occupied portion can use Section 121, on the same principle as Situation One.

Attorney’s Insight

In New York, “you can’t do a 1031 on your home” is only half true. Many owners of two- and three-family houses could have combined the Section 121 exclusion with a 1031 deferral, but no one planned it for them in advance. Our advice:

• Before selling, decide how to allocate between “home” and “rental.” Allocation is usually based on square footage or an appraisal. It should be reasonable, supported and consistent with the depreciation you have claimed on past returns;
• Rent it like a real landlord: a written lease, market rent and timely tax reporting. Token rent from a relative is hard to defend to the IRS;
• Don’t rush to move into the replacement. The five-year holding requirement and proof of investment intent decide whether your future exclusion survives;
• Watch the three-year window after moving out. If you plan to sell a former home, selling within three years of moving out preserves both the Section 121 and 1031 benefits.

Attorney’s perspective

Whether a home can qualify often depends on how it has been used and what you plan next. We weigh the home-sale exclusion and the 1031 rules together to find the best combination for you.

For advice about your own situation, call +1 718-218-5805 or schedule a consultation. We meet clients in Flushing and Manhattan, in English or Chinese.

Series overview

This article is for general information only and is not legal advice. Reading it does not create an attorney-client relationship. For advice about your situation, please contact us.

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