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Can we move into our 1031 exchange property?

Dear Tax Talk,
I saw your article on Aug. 3, 2005, on avoiding capital gains taxes with 1031 exchanges.

We successfully completed a 1031 exchange in December 2004. We are now renting out the new house, but would like to move into this house when the lease is up. We think that we can sell our current residence without capital gains taxes since we have been living there for 22 years. However, can we legally move into the new rental property without voiding the 1031 exchange done in 2004?
-- Frank

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Dear Frank,
At least you thought to ask before you shot yourself in the foot. In a Section 1031 exchange, you change one property held for investment for another. The gain that you realize on the exchange is deferred into the cost of the replacement property. If you later sell the replacement property, you pay tax on the deferred gain plus the appreciation in the replacement property. It's a good deal because you can continually trade up for bigger property using the equity in the relinquished property without paying income taxes.

If you change the use of the replacement property into personal use, you run the risk of the Internal Revenue Service disallowing the Section 1031 exchange. In your case, this would mean that you would pay tax on the exchange in 2004 since you did not trade for investment property.

Unfortunately, there is no safe harbor for determining when you can convert the investment property to personal use without running the risk of losing the exchange benefits. If the IRS interprets your move as part of a preconceived plan, it could be several years before you are safe. Since an examination is always done a couple of years after you file your return, the IRS has plenty of hindsight to detect a preconceived plan. I would say that to be fairly safe, you're probably looking at a minimum of three years from the date of the exchange.

Bankrate.com's corrections policy -- Posted: Aug. 10, 2005
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