Is There a 1031 Exchange 5-Year Rule?
A five-year holding period on properties is not a requirement to make a 1031 exchange on investment properties. However, there is a five-year holding period that may apply if you decide to make a property you acquired using 1031 exchange into your primary residence.
Understanding what the five-year rule refers to and how it relates to a 1031 exchange can help you make more informed decisions regarding your property and tax situation. Here’s what you need to know.
Is There a 5-Year Rule for 1031 Exchanges?
As mentioned, there’s no official "5-year rule" for 1031 exchanges under IRS guidelines. While there is no set duration required to qualify for a 1031 exchange, the IRS expects that properties involved in the exchange must be held long enough to demonstrate genuine investment intent.
The IRS may challenge exchanges involving properties held for a very short period if they suspect that the properties were not purchased with the intent to hold them for investment.
Where Did the 5-Year Rule Come From?
The confusion surrounding the "5-year rule" in 1031 exchanges likely stems from a mix-up with other tax laws and investment strategies, particularly the income tax provisions of the American Jobs Creation Act of 2004. This legislation amends Section 121 of the Internal Revenue Code (IRC) to allow homeowners to exclude up to $250,000 of capital gains tax ($500,000 for married couples filing jointly) on the sale of a primary residence that was initially acquired through a 1031 exchange. That said, there are particular rules and timelines that homeowners need to follow to do this successfully.
How Does the 5-Year Rule Work With a 1031 Exchange Property?
If you want to take advantage of the Section 121 capital gains tax exclusion on a primary residence that you initially acquired through a 1031 exchange, there’s a specific set of steps you’ll need to follow. Failure to do so may result in you owing immediate capital gains tax on the sale of your property. Here’s how the process works.
1. Acquire an Investment Property Through a 1031 Exchange
The first step in this process is to acquire a property via a 1031 exchange. The process begins by selling your original investment property and then identifying a replacement property within 45 days. The new property must be of equal or greater value and be used for investment or business purposes. The exchange must be completed within 180 days of the sale of the original property. A Qualified Intermediary typically facilitates the exchange, holding the funds from the sale until they are used to purchase the new property.
2. Convert the Investment Property to a Primary Residence
You typically must utilize the property as an investment property for at least a couple of years before you can convert it to your primary residence. Keeping detailed records of the property as an investment asset is essential, as the IRS requires that properties acquired in a 1031 exchange be used for investment or business purposes only. If the IRS suspects you completed a 1031 exchange with the intent to immediately use it as your primary residence, the exchange can be disallowed.
To establish the property as your primary residence after using it as an investment property, you’ll need to live in it for two of the five years before selling. The years don’t have to be consecutive for you to qualify for the exclusion.
Exceptions to the 2 out of 5-Year Rule
While the IRS requires you to inhabit a property for two of the last five years for it to quality as your primary residence, it does offer exceptions to this rule in some instances. Here are some examples of the circumstances that may qualify you for a partial capital gains tax exemption even if you didn’t live in the property for at least two of the last five years:
- Divorce or separation
- Death of a spouse
- You were a service member
- You moved for work- or health-related reasons
- You became eligible for unemployment benefits
- Your previous home was destroyed
3. Hold the Property for a Total of Five Years
Once you’ve established the property as your primary residence, you’ll still need to complete the five-year holding period. This is where the 5-year rule comes into play. You can only qualify for the capital gains tax exclusion on the sale of your primary residence if you hold the property for a total of five years from the initial date of acquisition via the 1031 exchange.
4. Exclude Capital Gains Taxes According to Section 121
After the 5-year holding period is up, you’re free to sell your primary residence and benefit from the capital gains tax exclusion under Section 121. Remember, this allows you to exclude up to $250,000 in capital gains tax for single filers and $500,000 for married couples filing jointly.
The 5-Year Rule and 1031 Exchanges Are Related, but Not the Same
The "5-year rule" is not something that applies directly to 1031 exchanges—the IRS does not set a specific holding period requirement for tax deferral. Instead, the rule refers to a requirement you must meet in order to benefit from capital gains tax exclusion on the sale of your primary residence if you initially acquired the property as part of a 1031 exchange. It’s important for investors and homeowners alike to have a full understanding of these rules and how they work in order to achieve their financial goals when selling property.
To navigate the complexities of a 1031 exchange, it's always wise to consult with a Qualified Intermediary, like First American Exchange Company. Contact our team today to learn more.