Conversion to personal use – 5 year holding period required

A fairly common strategy of Investors is to convert investment property acquired as part of a 1031 exchange to personal use and then dispose of the property under the provisions relating to the sale of a principal residence.  Section 121 of the Internal Revenue Code provides that a taxpayer may exclude up to $250,000 ($500,000 for a married couple) of the gain recognized from the sale of a principal residence if the property was utilized as the taxpayers principal residence for two of the previous five years.

On October 22, 2004, President Bush signed into law corporate and foreign tax legislation that also contained a provision affecting IRC §1031. Under this provision, an Investor who performs an IRC §1031 tax deferred exchange into a Replacement Property that is later converted to the Investor’s principal residence is not allowed to exclude gain under the principal residence exclusion rules of IRC §121 unless the sale occurs at least five years after the closing date of the Replacement Property purchase.  The actual provision reads as follows:

Sec. 840. Recognition of gain from the sale of a principal residence acquired in a like-kind exchange within 5 years of sale. (10) PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE — If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property.

The change to IRC §121 is effective for principal residence sales occurring on or after October 22, 2004 and all investors who previously acquired their current residence through a §1031 exchange within the past three years will now have to wait at least two more years before selling their residence to exclude the gain. This assumes they meet the two out of five year principal residence test.