We are about to purchase a rental house through a 1031 exchange and want to rent it out while we live overseas for 3-5 years. Is there any way we could move into the rental as a personal residence after we come back without affecting the benefits of the 1031 exchange?

In your particular situation, the short answer is yes.

Because 1031 exchanges are a great way to defer paying large amounts of capital gains tax, the IRS tends to be suspicious of them. They have rules where they go back and examine whether property gained through a 1031 exchange really has been used for business or investment use (rental property counts as “investment”) or whether the 1031 exchange was just a ruse to dodge taxes on personal property.

Thankfully, their lookback rules are public. Revenue Procedure 2008-16 describes the tests they apply specifically for real estate. As long as you owned the property given up in the 1031 exchange for two years before the exchange, rented it for at least two weeks a year, and personally used the property less than 10% of the time it was rented, that half of the 1031 equation is satisfied. For the property you receive, the exact same rules apply.

So if you keep the new rental house for two years before you move in, rent it for at least two weeks a year, and personally used it less than 10% of the time it was rented, the IRS will say that you really did intend to buy this as a rental and not just as a way to dodge taxes on buying a personal home. Since you plan to live overseas for three years, you will definitely satisfy the first and third requirements, so as long as you can manage to rent it out, you should be fine with the IRS.

Having acquired the property through a 1031 exchange means you need to remember two things if you ever plan to sell that house after you move in. First, the 1031 exchange affected the cost basis of the house. The new property’s basis should be equal to the cost basis of the property you gave up minus any money you received for taking the new house, and increased or decreased by the difference in value between the two properties. That is, if the new property was worth more, your basis increases and if it was worth less, your basis decreases.

Finally, you need to have owned the house for five years and lived in it for two to be able to claim the normal $250,000-per-person exclusion from capital gains from the sale of a personal home. Since 2008, however, the rules say that if you rented your house in any of the five years before you sell it, you need to reduce the exclusion proportionately.

That means you could find yourself in one of three scenarios when you sell.

Scenario 1: you rent the new house for three years while you’re overseas, move back in for one year, and sell it. Renting it for two years satisfies the 1031 exchange, but since you didn’t own it for five, you get no reduction in capital gains on the sale.

Scenario 2: you rent the new house for three years while you’re overseas, move back in for two years, and sell it. Again, you satisfy the 1031 exchange and since you owned it for five years, you qualify for partial exclusion of capital gains. Assuming you’re married, you would take the full credit of $500,000 and reduce it to 40% because you only used it as a primary residence for two years out of the five in question. That means you can ignore the first $200,000 of capital gains on the sale.

Scenario 3: you rent the new house for three years while you’re overseas, move back in for five years, and sell it. Since the law only looks back five years and you rented the house 6-9 years ago, its initial nature as a 1031 property doesn’t affect your capital gains exclusion. You get the full exclusion of $500,000.

With careful planning, you should be able to acquire rental property through a 1031 exchange and defer the tax, rent it out, occupy it later, and then sell it with the full homeowner’s exclusion on the taxes you deferred in the first place.

Photo used here under Flickr Creative Commons.