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I recently sold my rental property (owned for 5yrs, rented out for the last 3.5yrs) and netted $50k. I am currently under contract to purchase a new house for $55k down that I plan on living in. The seller is having a hard time finding a new residence and is asking for another month. This is fine with us as we are currently renting on a month to month basis.

I know that as it currently stands, I am set to pay capital gains tax on the $50k, which sucks. I am considering purchasing the house we have a contract on as an investment property and have the seller "rent" it for the next month. Will this let me file a Section 1031 exchange?

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  • You intend to live in it after the first month? – Hart CO Feb 21 '20 at 18:48
  • Correct. We plan on living in the new house fulltime but are flexible on the start date. – Nick Schild Feb 21 '20 at 18:54
  • What is the problem with simply signing the contract to buy now, but putting the closing date one month later? Then you don't have to worry about renting it for a month. – DJClayworth Feb 21 '20 at 18:55
  • @DJClayworth Nothing, that is our current plan. I just see a possible opportunity to pay fewer taxes next year. – Nick Schild Feb 21 '20 at 18:57
  • How does renting it out for a month reduce taxes? I believe you would pay tax on the rental income. – DJClayworth Feb 21 '20 at 19:11
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If the intent is for the new property to be a primary residence, then 1031 exchange does not apply.

You can convert a 1031 exchange property to a primary residence but to avoid the prior exchange being invalidated you would have to rent it out for part of 2-years and limit personal use, per IRS guidance :

(2) Replacement property. A dwelling unit that a taxpayer intends to be replacement property in a § 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:

  • (a) The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”); and
  • (b) Within the qualifying use period, in each of the two 12-month periods immediately after the exchange,
    • (i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
    • (ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

The above is just safe harbor language (they won't challenge you on the validity of the exchange if you meet those requirements).

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Here's how you handle that. You communicate your requirements to your agent, and they make sure the seller knows. The. You close at a date that meets your requirements, and rent it back to them for as long as they need. This is a pretty common situation, done precisely to bridge this sort of timing situation. If they have any doubts about this, their Realtor will set them straight.

However, you must also heed the IRS rules for a 1031 exchange, mainly that it must be rental property to rental property. HartCO has posted those, and it seems to preclude any appreciable personal use. You might want to stay where you are and rent it out for 2 years. You could move in for <14 days after the homeowner leaves and DIY-repair things you can only DIY repair on owner-occupied units, e.g. Electrical. Don't push it to 30 days on the hopes of renting it for at least 10 months, because that might fall through.

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