Can a 1031 Property Be Converted to a Principal Residence?

by Maura Snabes, Esq., CES, NTP

April 2025

In real estate, it's often said that the three most important factors are location, location, location. When it comes to a 1031 Exchange, it's all about intent, intent, intent.

During an audit, the IRS will closely examine whether the taxpayer had the proper intent regarding the use of the real property. To qualify for tax deferral under Section 1031, the property must be held for use in a trade or business or for investment purposes.

While the IRS does not define a specific minimum holding period, it does provide a safe harbor: if a property is used as a rental for at least 24 months—rented at fair market value for at least 14 days per year, and not used for personal purposes for more than 14 days or 10% of the days it was rented—it will likely qualify.

But what if circumstances change and you want to convert an investment property into your primary residence?

Good news: it’s possible. However, strict IRS rules must be followed to avoid disqualifying the exchange and triggering a hefty tax bill.

Key Considerations

1. Establishing Investment Intent.
   The IRS focuses on your intent at the time of the exchange. You must demonstrate that the property was originally acquired for investment or business purposes—even if that intent changes later. Keep thorough documentation, especially if your plans shift.
2. Five-Year Holding Requirement.
   If you convert a 1031 replacement property into your principal residence, you must own it for a minimum of five years before you can potentially qualify for the Section 121 exclusion (which allows tax-free capital gains on the sale of a primary residence). Additionally, you must live in the property for at least two of those five years.
3. Two-Out-of-Five-Year Rule.
   To benefit from the Section 121 exclusion, the property must have been your primary residence for at least two of the five years immediately before the sale.

Exclusion Limitations

The Section 121 exclusion—up to $250,000 of gain for single filers or $500,000 for married couples filing jointly—is reduced proportionally based on the time the property was not used as a primary residence during ownership. This rule applies to exchanges completed after January 1, 2009.

Example:
You purchase a property through a 1031 exchange in June 2020, rent it out for 2 years, and then use it as your primary residence for the next 3 years. When you sell in June 2025, 60% of the gain (3 out of 5 years) may be excluded under Section 121, and the remaining 40% is taxable. Note: Any depreciation taken during the rental period must still be recaptured and taxed upon sale.

Flexibility on Holding Period

Although the IRS offers a 24-month safe harbor, there’s no statutory minimum holding period. If you can clearly demonstrate your investment intent, converting the property sooner is possible—some experts suggest that a one-year holding period (or some other period) may suffice, depending on the situation. Be sure to consult your tax expert. 

Again, just keep in mind that any capital gains must be prorated between qualified (primary residence) and non-qualified (investment) use, and depreciation must always be recaptured.

Final Thoughts

It’s common for investors to pivot and turn an investment property into a primary residence. However, failing to properly establish and document your original intent can lead to serious tax consequences. Always consult with experienced tax and legal professionals before making any changes, and keep thorough records to support your intent—especially in the event of an IRS audit.