When you sell an investment property, such as a house, condo, apartment building, or commercial property, you are usually required to pay a capital gains tax on the profits. However, you may be able to postpone your capital gains tax liability by completing a 1031 exchange, which is a like-kind exchange to another property of equal or greater value. The rules are complex, the time frame is short, and it is easy to make mistakes that could result in a large tax bill or a hasty purchase that may not be a good investment. Here’s everything you need to know about the 1031 exchange primary residence in California, as well as the answer to the question, “Can I convert a 1031 exchange primary residence in California?” So, first and foremost, what is a 1031 exchange?
What is a 1031 Exchange?
With a standard 1031 exchange, investors can put off paying capital gains taxes on the sale of an investment property, which can save them a lot of money on their taxes. It also makes using leverage to upgrade to a larger or better-performing property easier. This is a great way to invest if you want to add a different type of property to your portfolio or just choose properties that are easier to manage, like triple-net lease properties.
A 1031 exchange, on the other hand, can be done on personal properties, including one method savvy investors can use to legally defer federal capital gains taxes on a primary residence.
Can You Do 1031 Exchange Primary Residence
Investors in real estate can often avoid paying capital gains taxes by putting off payments to the IRS through 1031 exchanges. A 1031 exchange allows property owners to take the proceeds from the sale of one property and invest them in another. They can use the money from the sale to buy another similar property without having to pay extra taxes. As long as these two properties are of equal value and all other IRS requirements are met, the owner is exempt from paying taxes until the replacement property is sold.
When a homeowner sells their home and plans to purchase another, they may wonder if a 1031 exchange will allow them to avoid paying taxes. So, when is a 1031 exchange for a primary residence permissible? “Rarely,” is the short answer to this question. Unfortunately, most primary residences do not meet the IRS’s 1031 exchange requirements. Homeowners, on the other hand, can avoid capital gains tax in other ways. Learn everything you need to know about 1031 exchanges for a primary residence in California as a homeowner in 2022 by reading on.
Six Important Terms to Understand
#1. Capital Gains and Income Tax
Without understanding capital gains and capital gains tax, it is impossible to understand 1031 exchanges or any of the other terms on this list. A capital gain or capital loss, as defined by the IRS, is “the difference between the adjusted basis and the amount you realized from the sale of a capital asset.” When someone profits from the sale of an asset, they have capital gains. Capital assets are any type of personal property, including houses, furniture, stocks, and other investments.
The term “adjusted basis” refers to how the cost of a capital asset changes over time while it is owned. Improvements made to the property during ownership can raise the adjusted basis. On the other hand, depreciation can reduce the basis because it reduces the fair market value of the property at the time it was purchased. A decrease in the basic means that the capital gains tax you owe when you sell may increase. When people sell commercial or residential real estate, the IRS often takes out a capital gains tax, but not always. Capital gains tax is classified into two types: short-term and long-term. Whether short-term or long-term capital gains taxes are due, they must be paid after an asset is sold.
Capital Gains Tax on Short-Term Gains
Jason Fernando explains both short-term and long-term capital gains taxes on real estate in his article “Capital Gains Tax” for Investopedia. According to Fernando, “short-term capital gains tax applies to assets sold within one year of the date they were purchased.” The profit made by previous owners from the sale of their property is taxed as “ordinary income” in these cases. Regular income tax is “a higher tax rate than the capital gains rate” for the vast majority of taxpayers.
Capital Gains Tax on Long-Term Gains
Long-term capital gains are profits made after the sale of a property owned for more than a year. According to Fernando, “the capital gains tax rate only applies to profits from the sale of assets held for more than a year.” Currently, taxes on long-term capital gains are “0%, 15%, or 20%, depending on the taxpayer’s tax bracket for that year.”
Long-term capital gains taxes change “based on the taxpayer’s taxable income and a rate schedule.” Not all homeowners or real estate investors who sell their homes for a profit will have to pay capital gains tax. Some people don’t have to pay taxes on capital gains, and other people can put off paying capital gains taxes because of exceptions in the tax code. This is further explained in our section on the five-year rule.
#2. The Five-Year Rule or the Two-Out-of-Five-Year Rule
The five-year rule, also known as the “two out of five years” rule, allows homeowners to benefit from a home sales exclusion. To qualify for this exclusion, the homeowner must have lived in their home for at least two of the last five years. In his article “Do You Have to Pay Capital Gains Tax on the Sale of Your Home?” for The Balance, William Perez explains. According to Perez, some homeowners are eligible for the Section 121 Exclusion, also known as the “home sale exclusion.” According to this part of the Internal Revenue Code, single people can avoid paying capital gains tax on up to $250,000 in profits from the sale of their main home.
Married taxpayers filing jointly are allowed to “exclude up to $500,000 in gains.” This means that if you bought your home for $400,000 and sold it for $600,000, you would not be required to report any profit to the IRS as taxable income. If you sold that same home for $800,000, you would have to report $150,000 of the profit as taxable income on your tax return. Major home improvements and closing costs can be added to your cost basis, reducing the difference between what you paid for your home and what it sold for.
#3. 1031 exchange
The topic of this post is next on our list of terms to learn: 1031 exchanges. When it makes sense, the 1031 exchange lets California property owners avoid paying capital gains taxes when they sell their main residence or commercial property. As Robert W. Wood explains in his Forbes article “1031 Exchanges Save IRS & State Taxes, Even If You Leave California” in 2019. “Under 1031, if you exchange real estate for ‘like-kind’ real estate, the gain is postponed until you sell your replacement property,” writes Wood.
Some real estate investors are known for doing a long series of 1031 exchanges so that they don’t have to pay taxes for a long time. The property in question must usually be a commercial or investment property. It cannot be your residence. However, because the term “like-kind” is so broadly defined, there are some exceptions.
What Is the Process of a 1031 Exchange?
Of course, sellers cannot wait indefinitely to purchase a replacement property when performing a 1031 exchange. “The replacement property must be selected within 45 days of the transfer of the property that was given up,” Wood says. The relinquished property is the one that was sold to initiate the 1031 exchange. That seller has to close on their new home 180 days after the date of the transfer or when their tax return is due, whichever comes first. Whichever comes first is the deadline for transferring the title to the replacement property. From here on out, the 1031 exchange primary residence in California process gets more complicated and less clear.
“Section 1031 requires relinquished property to be exchanged for replacement property,” Wood explains. The IRS, on the other hand, allows investors to use “qualified intermediaries,” or QIs. In subsequent posts, we will go over this in greater detail. For the time being, however, homeowners should be aware that 1031 exchange rules vary by state. If homeowners have any questions, they should always consult a tax professional.
#4. Property of the Same Kind
As was already said, the two properties that are traded must be “like-kind” for a 1031 exchange and a deferral of capital gains tax. James Chen writes for Investopedia about what “like-kind” means in real estate and, more importantly, what it means to the IRS. According to Chen, “The term like-kind property refers to two real estate assets of a similar nature, regardless of grade or quality, that can be exchanged without incurring any tax liability.”
In most cases, like-kind properties involved in an exchange must be treated as real property. Section 1031 requires that this property be held for business or investment purposes. As a result, personal residences are rarely considered “like-kind properties.” To qualify for a tax deferral, a like-kind property must also be located in the United States.
#5. Partial 1031 Exchange
In some cases, California homeowners may choose to do a partial 1031 exchange on their main residence. In his MillionAcres article “What is a Partial 1031 Exchange?” 1031 exchanges are partially explained by Matt Frankel, CFP. Frankel says first and foremost that “a 1031 exchange lets you put off paying taxes by putting the money from the sale into a new property.” He then points out that the proceeds from a sale do not have to be used entirely to fund a like-kind purchase. “You can choose to take some money off the table upon the sale of an investment property while still deferring the majority of your tax liability,” Frankel says. The IRS refers to this as a “partial 1031 exchange.”
In most cases, the IRS requires that both investment properties in a 1031 exchange have equal debt, equity, and value. This, however, is not always the case. While deferring taxes, Frankel writes that “it is possible to buy a property for less than the original property’s sale price or with a mortgage that is less than the balance owed at the time of the sale.” The price of the property that was given up may be different from the price of the property that was bought to replace it. If you paid less than you earned, you must pay taxes on what the IRS refers to as “boot.” Capital gains taxes on “boot” cannot be deferred.
#6. Rollover Rule
The “rollover rule,” which was repealed as part of the Taxpayer Relief Act of 1997, is our next term. When a homeowner sold one home and bought another, the rollover rule allowed them to defer capital gains tax. The rollover rule was similar to the 1031 exchange in many ways, except that it applied to primary residences rather than investment properties.
Kass says that “the rollover allowed homeowners who sold their main home to put off paying tax on any profit if they bought a new home within two years at a price equal to or higher than the sale price of the old home.” The Home Sale Gain Exclusion rule allows homeowners to avoid paying capital gains tax on a certain amount of profit today. This rule allows homeowners to exclude capital gains taxes rather than defer them.
Can I Convert 1031 Exchange Primary Residence
“Can I convert a 1031 exchange into a primary residence in California?” is a question that comes up often. Unfortunately, the IRS’s short answer is an emphatic no. A 1031 exchange is used to put off paying capital gains taxes on an investment property. Your home is your home. However, as is customary under the Internal Revenue Code, there are exceptions.
Consider the following scenario: Suppose you decide to convert your 1031 exchange primary residence into a rental property. Let’s say you turn your primary residence in a 1031 exchange into a rental property and rent it out to tenants who have possession while you no longer live there. In that case, you could use it in a 1031 exchange later on. In fact, this is a common way for people to start investing in real estate: they buy a new home and keep the old one, turning the old one into an investment asset that makes money.
Even though the tax code doesn’t say how long you have to rent out the property, most tax experts and CPAs say that you should rent it out for at least two years at fair market value to prove that it is a legitimate investment asset.
The IRS is unequivocal on two points:
- To start, simply declaring your home as a rental property is insufficient.
- Second, you are not permitted to live in your home while it is being rented out.
So you’ve determined that your property is no longer your primary residence, but rather a rental property. So you can now perform a 1031 exchange and defer all capital gains from the sale of that property. Remember that a 1031 exchange, when done correctly, allows you to defer 100 percent of the capital gains taxes on the sale of real estate.
When Can You Do a 1031 Exchange on Your California Personal Residence?
When selling their previous home and purchasing a new one, most homeowners will simply take advantage of the home sale exclusion rule rather than attempting a 1031 exchange. However, there are some circumstances in which a 1031 exchange of a primary residence in California can be used to defer capital gains.
According to Frankel, “a 1031 exchange generally only involves investment properties.” As a result, “your primary residence is usually not eligible for a 1031 exchange.” Your vacation home, where you spend a few months of the year, is probably not either. On the other hand, people who own rental properties may be able to use both the primary residence exclusion rule and a 1031 exchange to their advantage.
A 1031 exchange on a primary residence that has been turned into a rental or vice versa is a good way to invest, but it is hard to do. This is why you should put together a team of professional advisors from Westwood Net Lease Advisors.
Frequently Asked Questions
WHAT DOES NOT QUALIFY FOR A 1031 EXCHANGE?
A primary residence is usually ineligible for an exchange because it is not used for trade, business, or investment. However, a portion of the primary residence used in a trade or business or for investment may be eligible for a 1031 Exchange.
WHAT DOES A 1031 EXCHANGE COST?
The cost of exchange varies according to the situation and type of exchange. A true property swap can cost as little as $500. The cost of a delayed exchange of two properties begins at around $1,000. Complex transactions, such as reverse or improvement exchanges, begin at $6,500.
HOW DO I GET STARTED IN A 1031 EXCHANGE?
It is as simple as calling your exchange facilitator to begin an exchange. You should have information about the parties to the transaction at hand before making the call. During the phone call, the exchange coordinator will ask about the property that is being given up and any property that is being considered as a replacement.