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Robin D.
Robin D., Senior Tax Advisor 4
Category: Tax
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Experience:  15years with H & R Block. Divisional leader, Instructor
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1031 exchange questions - I own a rental property that I

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1031 exchange questions -

I own a rental property that I plan to 1031 exchange to another rental property at some point. Couple questions:

1. What is the "safe harbor" time period after which I can convert it to primary residence? What needs to happen during "safe harbor" period? By "safe hard" I mean that IRS will still treat it as 1031 exchange, not an outright sale.

2. When it is time to sell the property obtained from 1031 after it has been converted to the primary residence, I understand my deferred depreciation capture on the previous rental property will now be realized and I understand the tax treatment of capital gain on the sale of the new property (gain attributed to the rental period must excluded from section 121 exemption). My question is what happens to the capital gain on the sale of the previous property and that was deferred?

A hypothetical example:

Current property: 250k basis, depreciation taken 40k, capital gain 50k.
Future property acquired through 1031: 350k basis, depreciation taken 20k, capital gain 80k.

When I sell the future 1031 property, I will need to pay depreciation recapture of 60k (40k on previous property, 20k on 1031 property), and I will have to exclude a portion of 80k from 121 exemption. But what happens to the 50k on the previous property?

Robin D. :

Hello and thanks for trusting me to help you today. I am a tax adviser with over 15 years of experience.
The safe harbor rule is not really a rule at all. There is noting in the tax code that states a specific time frame that would show you were not selling a property to buy a new home.
With that being said, it is your intent that will be important. Are you using this replacement property for rental or income purposes? Are you generating income with the replacement property? Are you leaving it to sit empty until you can inhabit?
If you hold the property for 2 years then you may be allowed to change to personal use without any questions. A holding period of over a year has generally been accepted, but may be subject to review by the IRS. A much shorter holding period has been accepted, where a change in circumstances indicates that the taxpayer had intended to hold the property for a longer period.


Robin D. :

When you look to possibly sale the replacement property that is now your personal residence, the property must not have been the subject of a 1031 Exchange in the previous 5 years (that is, 5 years from the closing of the phase 2 acquisition).

Robin D. :

As long as you adhere to that you can use the 121 for exclusion of gain under the regular rules.

Robin D. :

Any amount you can exclude would of course be taxable at the time of the sale.

Robin D. :

My goal is to give you excellent service. If you are satisfied, please rate me. If you have follow-up questions on this same topic, use the reply box below. To start a new conversation with me on a new topic request me again.


 

Customer:

Hi Robin,

Customer:

Thanks for the responses.

Robin D. :

You are most welcome.

Customer:

Now back to the question on the deferred CG on the previous rental property.

Customer:

Are you saying it will be due at the sale of the replacement property?

Robin D. :

It will be applied to the basis of the replacement . The replacement property carries the basis of the old property.

Customer:

I thought only the depreciation amount is applied to the basis, not capital gain

Customer:

since capital gain is taxed at different rate

Robin D. :

Any gain deferred in the exchange reduces the property’s cost basis if you change to personal use. You also will have to pay tax on any depreciation should you sell the property regardless of how much gain you can exclude under the capital gain rules for principal residences.

Customer:

ok, thanks for clarification.

Robin D. :

The deferred gain reduces the basis when you change to personal (so that is why you do not pay tax right away). This means that when you do sell you most likely will have a much larger gain that the 121 cannot (maybe) wipe out.

Robin D. :

You are most welcome.

Robin D. :

Your positive rating is always thanks enough.

Robin D. :

I am sure all of Just Answer would agree with me when I say thank you for your continued use of Just Answer. Much appreciated.

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