Restrictions Apply on Tax-Free Deferred Exchange of Homes

Question: Ten years ago after the “crash” we bought a rental home in North Phoenix. This rental home has appreciated in value by $200,000 in the last ten years. We now want to sell this North Phoenix home, and to use the $200,000 sale proceeds to build a home in Chandler as our personal residence. We do not want to pay any tax on the $200,000 capital gain on the sale of the North Phoenix home. Can we use a section 1031 tax-free deferred exchange to sell the North Phoenix home and use these $200,000 sale proceeds to build our personal home in Chandler?

Answer: First, you can only do a tax-deferred exchange between two investment properties. A personal home is not an investment property. Therefore, if you sell your North Phoenix home and build your personal Chandler home, you will have to pay capital gains tax on the $200,000 sale proceeds of the North Phoenix home. Second, under IRS rules, however, you could eventually get the benefit of a tax-deferred exchange if you use the $200,000 sale proceeds from the North Phoenix home to build the Chandler home, and then rent the Chandler home to a tenant for at least one year. In other words, you would not pay capital gains tax on the $200,000 sale proceeds of the North Phoenix home because the Chandler home was an investment property for at least one year. After at least one year as an investment property, you should be able to move into the Chandler home without losing the $200,000 benefit of the earlier 1031 tax-deferred exchange.

Note: This area of tax law is subject to numerous IRS rules so you must contact your own tax advisor. For example, this tax-deferred exchange rule is not the same as the IRS rule that a homeowner has to own a home for at least two out of the previous five years to get the $250,000 single/$500,000 married tax exemption on the sale of a principal residence.