GMAC Real Estate "Five Year Rule" and Taxes on Second Homes
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"Five Year Rule" and Taxes on Second Homes

Takeaways

  • A 2004 law requires a primary home acquired by 1031 exchange to be owned for five years before selling and earning the IRC 121 exemption.
  • This rule isn't too imposing because the process of converting a 1031 exchange investment property into a primary residence takes a couple of years.
  • To claim the IRC 121 exemption you must live in the property for another two years.

Did you know?

  • This rule creates something of a "safe harbor" for 1031 exchange property owners who eventually sell the house as a primary residence.
Hold the home for five years to maximize tax benefits. If you originally acquired your current primary home through a 1031 exchange a little tax change created as part of the American Jobs Creation Act of 2004 comes into play. This new “five year rule” stipulation affects your ability to utilize IRC 121 when selling the home. IRC 121 exempts $500,000 for couples and $250,000 for individuals from tax in the sale of a home you occupied for at least two of the previous five years.

The "five year rule" slightly changes the game for second homes acquired through a 1031 exchange and then converted to a primary residence. Living in the home for two years is not enough to satisfy the IRS in this circumstance. You must own the property for five years before claiming the IRC 121 exemption. If you were selling a home not acquired through a trade, you would only have to own, and occupy, the real estate for two years before selling with a full IRC 121 tax exemption.

Although the new tax ruling created in 2004 is one more thing to keep track of when dealing with 1031 exchange property, it really isn't too heavy a burden in practice. You can only use a 1031 exchange to obtain investment property, and your tax professional will probably ask you to hold that property for at least two tax years to demonstrate to the IRS the new real estate is in fact investment real estate, and not for personal use.

After the two years when you shift that second home to your personal use, you still are required to occupy the property for two years before attempting to claim the IRC 121 tax exemption. At the bare minimum this process takes four full tax years of the required five as stipulated by the five-year rule.

Search for Second Homes for Sale

To search for a selection of second homes for sale, please visit the website of a GMAC Real Estate Office that serves the area where you'd like to buy a second home. To learn more about buying Second Homes or Vacation Homes, explore the rest of this section, or contact a GMAC Real Estate Agent.