I could be wrong, but I don't think option 2 is legal. If you convert the house to a rental property, you need to re-establish a cost basis based on the market value at the time you convert it. So, the cost basis would be 2.5 million, not 1 million, for purposes of the 1031 exchange. Then, you would probably owe taxes on the 1.5 million gain when you did the exchange and disposed of the property. Option 1 may work, but I'm not sure.
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