Blog > Understanding 1031 exchange rules for family living
In a 1031 exchange, a property is sold, and the proceeds are reinvested in a like-kind property to defer capital gains taxes. However, there are rules about personal use of properties involved in a 1031 exchange, including whether family members can live in the exchanged property.
Can Family Live in the Exchanged Property?
-
General Rule: Properties in a 1031 exchange must be held for investment or business purposes, not personal use. If the property is used as a residence (including for family), it may violate this requirement.
-
Safe Harbor for Rental Property:
- To qualify as an investment property, the replacement property should be rented at fair market value for at least 14 days per year and cannot be used personally for more than 14 days or 10% of the rental days per year, whichever is greater.
- If family members live in the property, they must pay fair market rent to meet these conditions.
-
IRS Scrutiny:
- If family members live in the home without paying fair market rent, the IRS could argue that the property is not held for investment purposes.
- This could disqualify the exchange, making the capital gains taxable.
-
Converting to a Personal Residence:
- After meeting the investment-use requirement (typically at least two years), you may convert the property to a personal residence. This includes letting family members live there rent-free if desired.
- If you later sell the property, you may qualify for the primary residence exclusion (up to $250,000/$500,000 in capital gains tax-free for single/married filers) after owning and living in it for at least five years (including two as a primary residence).
Key Takeaways:
- Family members can live in the property if they pay fair market rent, and the property is rented primarily as an investment property for at least two years.
- Avoid personal use or allowing rent-free living for family members during the holding period to ensure compliance with 1031 rules.
- After the required period, you can convert the property to a personal residence.
Always consult a tax advisor or real estate attorney for guidance specific to your situation.