reducing tax hit on investment-turned-residence

My husband and I live in a home we have owned for 4 years. It was originally investment property, but two years ago we sold our home in CA and moved into this property in a different state. We thought we were going to live there forever, but have now determined that can’t be the case. One reason is allergies (mine) and the other is because my husband has been unable to find satisfactory work in the new location.

We know that if we keep the property for 5 years, we will only owe taxes on the amount of gain over $500K. However, there will be an actual gain of over $1Million, so we are trying to find a way to do both a 1031 exchange AND take the residential deduction. I am of the understanding that is quite legal, if you live in the house for two years, and use it as an investment property on both the front and back ends. (I forgot to mention that we purchased it originally with a 1031 exchange).

The problem we face is that turning this home back into an investment will be very difficult for us logistically. We would like to go back to CA, buy a home to live in, and get on with our lives. HOWEVER, we would like to do so without paying any more in taxes than we have to.

I hope this is clear. Can anyone out there help? Any creative suggestions would be most welcome.


No need to be creative when it comes to taxes. Creativity there might get you as nice cozy 6 x 8 to live in!!!

Best advice, run it through your CPA and get their advice. If you don’t have one, then call some RE investor buddies and get some referrals.

A CPA experienced in REI taxes should be able to tell you pretty quick exactly what you can, and can’t, do and what you would likely have to pay in taxes if you do this, or that.

One thing, if you’ve taken deductions on this prop, then I believe that those will be recaptured on a sale whether you 1031 or not. Again, a CPA will know.


You only have to live in the house as a non investment property two of the past 5 years not the whole five years. Unless I read your post wrong.

If the gain is over a million dollars a tax attorney or CPA might be a reasonable expense.

Ha you thought about creating a deal with a buyer where you defer a portion of the selling price to future years? This would only benefit you under certain income conditions.

Thanks, Jeff in CT, but if you talk to a tax and/or 1031 expert, they will tell you that if the property was originally purchased as an investment, then converted it to a primary residence, you must live in it for 2 years AND hold it for 5 full years before you can claim your tax exempt $250K for each spouse.

I neglected to mention that I am also a licensed realtor, so I am very familiar with this tax code. What I am looking for is a creative way (please don’t read illegal), maybe with a rather complicated interplay of rent backs or whatever to be able to hold this house for 5 years AND do another 1031. It IS legal, if we can figure out how to do it and end up with a nice house to live in within a years time.

Any further help would be most welcome.

It would be hard to offer any good suggestions without a little more detail on what you actually have and what you may be willing to give to get the job done.


Okay, Raj…
My husband and I have a house worth about $1.8M in Hawaii. We purchased it in June of 2002 for $885,000. through a 1031 exchange. That was possible because of arental property we sold in Silicon Valley. We have now put in about $100K in capital improvements.

The first 2.5 years we used it strictly as an investment (vacation rental). We moved into it a little over 1.5 years ago. Now, because of unexpected allergies, we will be moving back to CA. We may be willing to purchase a home in CA, then rent it to someone for a short period of time so we can call it an “investment property” but are not sure how long it remain in that status.

Please let me know what additional info you would like to have.


Okay. First, if you’ve only lived in it 1.5 years as a primary, then you will need to stay for at least another 6 months to get the tax break, but you probably already knew that. It may be possible to get a partial break, but that can only be determined by your CPA and the IRS.

On to keeping it for another year. Take it for what it’s worth because I don’t know the Hawaii market (but can’t imagine that it’s anything but a seller’s), and don’t deal in houses of this value.

Are you willing to give up any of the equity in return of a reduced/delayed tax hit? Can you rent a $1.8 M property for your monthly payment (if any)?

Quick idea: Locate an area investor (preferrably referred if you don’t know any yourself) and see if they are interested in the property. Explain your situation, both so that each party is clear and that the investor knows that your not a “motivated” seller per se.

I’d suggest a lease/purchase deal with an investor who can sublease the property for a minimum of one year. In exchange, you’ll discount the price $300-500K from FMV. At the end of the term, the purchase contract kicks in and the investor buys. Don’t want to collect rent from the investor? Collect it upfront!

Another suggestion. Same basic deal, but in exchange for the investor covering your monthly costs, you’ll give permission to sublease (and get any profit) and you’ll split 50/50 any equity buildup over whatever number you feel is right be that current FMV or a discount of it.


Thanks Raj, these are some very useful suggestions and will give me some possibilities to explore. You never know what you will encounter when you put a house on the market here. Sometimes people want a lease-purchase or even a delayed purchase (agreement of sale), which is a little scary, but something I think we can live with.

I still welcome other thoughts on this - from anyone out there.