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Tips for Converting Rental Property into Personal Use Property

Encroachment Endorsement

When you do a 1031 exchange you need to acquire a replacement property that’s like-kind. The definition of like kind in the realm of real estate is very broad. A lot of people that have been holding single-family rental property (a small duplex or fourplex) may be inclined to buy a property as a replacement that eventually could be converted into a personal use property such as a second home. Here are some things to keep in mind when converting rental property into personal use property.

Qualifying Purpose

You need to be very careful that when you receive the replacement property you have the requisite intent to hold it for a qualifying purpose of investment or business use.

Sometimes people will buy a property that is a vacation type property and put it into a rental pool and predominantly they’re using the property as a rental property with incremental tenants. Now the taxpayers that have acquired this vacation property may be inclined to use it for personal use. Under a safe harbor that the IRS has you can use it up to 14 days a year or up to 10% of the time the property is actually rented.

IRS Guidelines

The IRS can test each of the two years after you acquire that replacement property to see if your personal use was within those guidelines. By the way if you go and use the property but you’re there predominantly to maintain the property (to repair it, paint it, or fix it) then those periods that you’re there for business would not count against your 14 days or 10% that you use it for personal use.

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Can You do a 1031 Exchange with a Property You’ve Lived in for Less than 2 Years

Title-Search

Recently I spoke to a client who was selling their house that they had lived in for less than 2 years. They had about $100,000 in capital gains on the home after all expenses. This taxpayer wanted to consider a 1031 exchange and was wondering if it was possible.

Principal Residence Exclusion

1031 may not be an option in this case if the house has been used as the taxpayer’s principal residence. For the IRC 1031 to qualify, you need to HOLD the replacement property for business or investment purposes.

It’s your home and generally speaking, you can’t do a 1031 exchange on your home. That’s usually not a big deal because under IRC section 121 the principal residence exclusion you get to take up to $500,000 of that profit tax return married filing a joint tax return or $250,000 for single filing.

Extenuating Circumstances

But what if you must move early (prior to the two year period) because of:

  • Job related circumstances?
  • Health reasons?
  • Or other unforeseen circumstances?

You may still be able to take a portion of the two year exclusion if any of the following apply.

  • 121(c)(2)  EXCLUSION FOR TAXPAYERS FAILING TO MEET CERTAIN REQUIREMENTS:

(2) Sales and exchanges to which subsection applies. This subsection shall apply to any sale or exchange if:

(A) subsection (a) would not (but for this subsection) apply to such sale or exchange by reason of–

(i) a failure to meet the ownership and use requirements of subsection (a), or

(ii) subsection (b)(3), and

(B) such sale or exchange is by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances.

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Do You Need to Reinvest the Net Proceeds or the Sales Proceeds in a 1031 Exchange?

Constructive Receipt

Many people who are looking into doing a 1031 exchange don’t really know how much they need to buy and reinvest in order to defer all of their gains. This article will walk through the basics of performing a successful 1031 exchange.

Buy Up

If you think about it as needing to continue your investment into a like-kind property of equal or greater VALUE and EQUITY, you’ll see that you need to buy a replacement property of roughly equal or more than what you sold your relinquished property for. You are able to net off certain transactional expenses like a realtor commissions, closing costs, etc., but if you want a rough rule of thumb, look at buying a replacement property at a higher price. Many tax problems can be solved by buying a more expensive replacement property.

Cash can Burn you with Taxes

The next element to look at is you don’t want to have any net proceeds go into your pocket. That cash would burn you with taxes. Remember to redeploy all of that cash (from the sale of your relinquished property) into your new replacement property.

Debt Relief

The last element to think about is debt relief. Any mortgages, liens, deeds of trust that you pay off on the sale of your old property need to be offset by either new debt or cash out of pocket. To summarize, buy a replacement property of greater value, reinvest all of your net proceeds, and offset any debt relief with new debt or additional cash. If you satisfy these rules of thumb, you’ll likely have an effective 1031 exchange.

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Why It’s Dangerous to Chase Yield in a Delaware Statutory Trust

Title Endorsements

Many investors that are looking at potential properties will investigate properties that are part of a DST (Delaware Statutory Trust) and oftentimes taxpayers get very myopic about the yield or the rate of return on the investment.

Chasing Yield

If you’re chasing yield you may do yourself a disservice because if the only thing you’re worried about is getting a 6.5% return, you may take on a property that has a much higher risk and a less certain outcome than if you would have settled for a property with a 5% return but was much more stable and solvent.

A very important aspect of choosing a replacement property is to look at the potential for underlying appreciation of the asset because at the end of this run when you are going to sell the underlying asset you want an asset that will have appreciated and not declined in value. So underlying the monthly rate of return is the more important appreciation of the asset itself.

After-Tax Cash Flow

Another consideration is to look at the after-tax cash flow from the property that would include depreciation and other deductions that pass through to you as one of the fractional owners of the underlying real estate.

Further, not all DSTs are the same when it comes to debt. Some have zero debt. Others have debt that may come due after 5 or 7 years. That maturity date on the debt can create a crisis if you have to sell the property to pay off the financing.

So there are a lot of different variables to look at when exploring what DST is the best for you. If you’re chasing yield alone, your eye may not be on the ball for these other very important facets of a DST.

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