Can I use an FHA or VA loan on a replacement property?

Government-backed loans are built for homes, and a 1031 replacement cannot be one

Section 1031(a)(1) defers gain only when property is exchanged for property 'to be held either for productive use in a trade or business or for investment.' A house you live in is held for personal use. Rev. Proc. 2008-16 quotes the appellate rule that 'use of property solely as a personal residence is antithetical to its being held for investment.'

The FHA rule runs the other way. HUD Handbook 4000.1 requires that 'at least one Borrower must occupy the Property within 60 Days of signing the security instrument and intend to continue occupancy for at least one year', and states flatly that 'Investment Properties are not eligible for FHA insurance.' 24 CFR 203.18 defines a principal residence as where the borrower 'typically spends (or will spend) the majority of the calendar year.'

VA is similar. Under 38 U.S.C. 3704(c) the veteran certifies, when applying and at closing, an intent to occupy the property as the veteran's home, meaning to move in 'within a reasonable time and to utilize such property as the veteran's residence.'

A two- to four-unit building is the one place the programs overlap

Both programs finance small multifamily buildings. HUD's handbook covers one- to four-unit properties, and the VA's definition of a dwelling in 38 CFR 36.4301 is a building 'consisting of not more than four family units' plus one more for each additional eligible veteran owner.

If you live in one unit and rent the other three, the building is split for tax purposes. The rented units are held for the production of rent and can be like-kind replacement property. Your unit is a residence, and the safe harbor in Rev. Proc. 2008-16 cannot cover it because it limits personal use to the greater of 14 days or 10% of the days rented each year.

Rev. Proc. 2005-14 shows the IRS allocating a single property between a residence and a separate business unit when one property is given up. The same allocation logic applies when buying: only the share of the price attributable to the rented units is replacement property. Practical fourplex economics are on the duplex and fourplex page.

Worked example: an $800,000 rental into a $1 million fourplex

Hypothetical, round numbers; run your own numbers with your CPA. You sell a debt-free rental for $800,000 with a $400,000 realized gain. You buy a $1,000,000 fourplex with four equal units, live in one, and rent three.

Roughly $750,000 of the price is the three rented units and $250,000 is your home. To defer all the gain, the investment portion must be worth at least the $800,000 you sold and absorb all of the equity. It is worth $750,000, so at least $50,000 of value is not replaced, and exchange money spent on your own unit is not spent on like-kind property. Expect at least $50,000 of boot.

The financing adds a second problem: an owner-occupant loan may carry a smaller down payment than you have equity, so the exchange proceeds you must reinvest may exceed what the lender needs. Cash left over after closing is boot as well; see leftover cash after a 1031 exchange.

What to do instead if you want both a home and an exchange

Separate the two goals. Exchange into investment property financed with a loan made for investors, and buy your home with an owner-occupant loan and money from outside the exchange. Every dollar the intermediary holds then goes into property that clearly qualifies.

If the long-term plan is to move into the replacement someday, the order matters: rent it first, under the rules in how long to rent before moving in, and be aware that a later sale as your home has its own five-year rule, covered in moving into a 1031 replacement.

Do not sign an occupancy certification you do not intend to keep. Telling a federal loan program you will live in a property and telling the IRS you hold it for investment are statements a lender or examiner can put side by side.

Passive replacements avoid the occupancy question entirely

For sellers whose aim is lower leverage rather than a new home, a Delaware Statutory Trust interest carries its own trust-level loan, so no personal mortgage application, occupancy certification or down payment rule is involved; see does a DST's loan count as replacement debt and our traditional DST page.