Converting an investment property into a personal residence
Over the years, many clients have asked me if they can convert an investment property or a rental house into their personal residence. The answer is yes, if you follow the guidelines.
Let me start by stating that I am not a tax advisor but a real estate broker. Please do not take this information as advice and buy your dream home. Talk to your tax accountant and a 1031 tax-deferred exchange intermediary who can guide you through a transaction and inform you of the tax consequences.
You could pay the taxes
If you own an investment property, you could sell it, take the cash and later purchase your new residence, but you will pay taxes. You will most likely end up paying capital gains tax, depreciation recapture, and possibly the 3.8 percent investment tax.
You could move in
If your investment property is a single-family house you could move in, change the utilities into your name using the property address for all your mail. The converted property would no longer be reported on your 1040 Schedule E (or through a K-1 for a pass-through entity) but your Schedule A. Your Schedule A is where you report your property tax and mortgage interest deductions.
Your mortgage lender may have issues if you are changing the property’s use or the title from an entity to your name. Likewise, the county tax assessor will scrutinize the title transfer. If the title is in an entity and it is changed to individuals, those individuals need to be the same owners of the entity. If they are not the same, you may have transfer tax to pay.
You could perform a 1031 exchange
If you own a small commercial strip center, for example, you could perform a 1031 tax-deferred exchange into a single-family house you rent to a tenant.
To satisfy the requirements of a 1031 tax-deferred exchange, the replacement property must be used for investment purposes to qualify as a “like-kind” exchange. “Like-kind” is more about the tax status (investment or personal) rather than the type of property.
Your initial intent of the exchange needs to be for investment purposes. You intend to rent the house at market value to a third party. There is no precise time to rent the property, but my understanding is that two years minimum is safe.
You could commit fraud
You are exchanging an investment property for your dream home; moving into it shortly after constitutes fraud. Or, keeping the house vacant for 18 months, never attempting to market for rent, securing a tenant, or showing income will undoubtedly be a red flag with the tax authorities.
You should have documentation of your intention to rent the house, including emails to your accountant and intermediary. Having a lease and showing investment income will solidify your intentions.
Having emails to your broker, accountant, or intermediary telling of your intentions to move in the day after closing will undoubtedly solidify your intentions as well. However it is legal to choose later to update your intentions and move into the house, but be sure you document a legitimate reason.
You may save taxes by strategically moving into a rental house you own or exchanging into your dream home, be sure you follow the guidelines and timing in doing so. Remember that if you had a prior exchange, you could end up paying taxes from that event when you or your estate sells the replacement house.
Burt M. Polson is the CEO of ACRESinfo.com, a commercial real estate brokerage company, and CEO of StoneMarkerInvestments.com, a private equity real estate fund. Call him at (707) 254–8000 or email burt@acresinfo.com and burt@stonemarkerinvestments.com.
