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Deferring and Potentially Avoiding Taxes on the Sale of Your Primary Residence – Part 1

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We frequently receive questions from owners of appreciated personal residences who ask us if it is possible to defer taxes on the sale of their personal homes using the 1031 Exchange. The answer which may surprise some readers is a conditional “Yes” – provided several important steps are followed which we will generally outline in this blog.
 
Rental property owners often utilize Internal Revenue Code Section 1031 (“1031 Exchange”) to defer taxes that would otherwise be due upon the sale of their business properties. The original 1031 Exchange rule dates to 1921 and has been used by many thousands of investors to defer and potentially avoid taxes and has the support of the IRS provided that specific rules are followed. 
 
Use of the 1031 Exchange to defer taxes is limited to the sale and subsequent purchase of business properties that are deemed to be “like kind.” Fortunately, the definition of “like-kind” is very broad and exchanges from most forms of business real property into other business real properties are allowed. Examples of permitted “like-kind” exchanges can include a single-family rental to an apartment or retail store, raw land into a rental property, etc. Essentially, any income property can be exchanged into any other income property or other permitted ownership structure such as Delaware Statutory Trust (DST).
 
If you are planning the sale of an appreciated personal residence, it may be useful to see if you can benefit from the process outlined below. Note that these steps have been simplified to convey the general concepts and you should seek the advice of qualified tax and real estate professionals based on a comprehensive analysis of how this strategy may apply in your personal situation. 
 
Step 1
 
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The first step is to convert your personal residence into an income property. This is done by moving out of the personal residence and then renting it out and receiving income from it for some period time. While IRS does specify a minimum rental period, many tax advisors suggest a minimum holding period of 1 to 2 years prior to selling and exchanging the property. 
 
Step 2
 
You obviously need to find a new place to live. Any net cash flow that you receive from the rental of your former residence can be used to either pay rent on a new residence – or make mortgage payments if you choose to buy a new residence rather than rent. In some areas of the US e.g., San Francisco Bay area, rental rates have escalated to a point where the income from a previous residence may be more than enough to rent a smaller residence in the same area – or allow you to move to a less costly area and enjoy the added income. 
 
Step 3