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Combining 1031 Exchanges and 121 Exclusions on the Sale of Real Property

Notice

The information contained within this article has been affected by the Housing and Economic Recovery Act of 2008 that was signed into law on July 30, 2008.  This article will be updated shortly to incorporate the changes contained in the Housing Bill.

Notice

The ability to defer or exclude depreciation recapture and/or capital gains from your taxable income is a tremendous and significant income tax planning strategy.  The deferral or exclusion of any expenditure, especially income tax liabilities, allows you to keep all of your equity invested and working for you.

The value of your real estate investment portfolio and consequently your net worth will grow exponentially faster when you defer or exclude the payment of income tax liabilities.  The difference between paying income tax liabilities now versus deferring or excluding them from your taxable income over an extended period of time will make a substantial difference in the long-term growth of your net worth.

You should always strive to manage your income tax liabilities by using tax-deferral or tax-exclusion strategies whenever possible.  There are a number of tax-deferral or tax-exclusion strategies available, but this article will focus exclusively on the joint application or combination of Sections 1031 and 121 of the Internal Revenue Code on the disposition (sale) and/or exchange of your real property.

1031 Exchange (Tax Deferred Sale of Investment Properties)

The ability to structure the disposition (sale) of your investment properties ("relinquished properties") and the subsequent acquisition of other investment properties ("like-kind replacement properties") pursuant to Section 1031 of the Internal Revenue Code ("1031 Exchange") has been available since 1921.  The 1031 Exchange allows you to indefinitely defer the recognition and payment of your depreciation recapture and/or capital gain income tax liabilities when disposing of (selling) one or more qualified investment properties and acquiring one or more qualified like-kind replacement properties.

Properties will be considered to be "qualified investment properties" if the properties are held for income production (rental or leased), held for capital appreciation (investment) or used in your trade or business.  Investment real property is considered to be "like-kind" as long as the properties involved satisfy this qualified use test.  This means that any kind of real estate would qualify as like-kind property to any other kind of real estate as long as the properties have been held for investment or used in your business. 

121 Exclusion (Tax Free Exclusion from the Sale of your Primary Residences)

You can also sell or dispose of your primary residence and exclude up to $250,000 in capital gains if you're single (per owner/person), or up to $500,000 in capital gains if you're married and filing a joint income tax return, from your taxable income under Section 121 of the Internal Revenue Code ("121 Exclusion").  The 121 Exclusion is a permanent exclusion from your taxable income (i.e. it's tax free; not tax deferred) and is a tremendous income tax planning strategy that you should seriously consider taking advantage of.

The requirements for a 121 Exclusion are fairly simple.  You must have owned, lived in and used the property as your primary residence for at least 24 months out of the last 60 months (2 out of the last 5 years) in order to exclude the capital gain from your taxable income.  You can take advantage of the 121 Exclusion once every two years.

In fact, many taxpayers do not — and should — pay close attention to the market value of their primary residence and the corresponding capital gain in order to determine if and/or when they should sell and lock in the tax free benefits of a 121 Exclusion.  The amount of capital gain in excess of the $250,000 or $500,000 limitation will generally be taxable, so they should at least consider selling when their capital gain is approaching the tax free exclusion limitation.

Multi-Use or Split Use Property and Property Conversions

It is not uncommon for a taxpayer to convert property from one use to another such as converting a primary residence into investment property by moving out of the property and begin renting it out or using it in his or her business, or by converting an investment property into a primary residence by moving into the property and treating it as his or her primary residence.  Property can also be used as both investment property and as a primary residence at the same time.

Historical Application of Section 1031 and Section 121

Prior to a recent ruling by the Internal Revenue Service, it was widely believed that the last or most recent usage of the property at the date of disposition (sale) would determine which income tax strategy was applicable. 

For example, if the property was held, treated and reported by you as your primary residence at the time of sale it was thought that the only option was to take advantage of the 121 Exclusion.  Alternatively, if the property had been held and treated by you as your primary residence in the past, but was actually held as investment property at the date of disposition (sale) it was thought that you had to decide whether to elect the 121 Exclusion treatment or the 1031 Exchange treatment, but you could not take advantage of both strategies. 

You could elect both a 121 Exclusion and a 1031 Exchange if the real property was used or held as investment property and as your primary residence concurrently at the date of sale (split use).  You could elect a 121 Exclusion for the entire property even if the property was partially held as investment property if the property is considered to be a single dwelling/structure (i.e. a single family residential property). 

Tax and Financial Planning Issues

These issues can present you with significant income tax and financial planning challenges if your properties have significant accummulated depreciation and/or capital gains.  You can not get much in the way of income tax relief from a 121 Exclusion if you bought your primary residence years ago at a very low cost basis and it is now worth millions of dollars. 

Converting your property from your primary residence and into investment property would have eliminated your ability to use the 121 Exclusion if you chose to complete a 1031 Exchange and electing a 121 Exclusion would have eliminated your ability to use the 1031 Exchange — that is until now. 

The Department of the Treasury surprised the investment community and issued a ruling in 2005 that defines and clarifies the application of Section 1031 and Section 121 on the sale or exchange of a single property.

Revenue Procedure 2005-14

The Department of the Treasury and Internal Revenue Service issued Revenue Procedure 2005-14, which provides an incredible new income tax and financial planning strategy to address a highly appreciated primary residence. 

The Revenue Procedure provides guidance on the application of Section 1031 and Section 121 to a sale, exchange or disposition of a single property that satisfies the requirements for both the tax-free exclusion of gain from the sale, exchange or disposition of a primary residence under Section 121 and the nonrecognition of gain on the tax-deferred exchange of like-kind properties under Section 1031.

You can exclude capital gain from a sale, exchange or disposition of a primary residence and may also benefit from a tax deferral of gain from a 1031 Exchange with respect to the same property.  The subject property must have been held, used and treated first as your primary residence and subsequently as an investment property or used in your trade or business.

Combining Section 1031 and Section 121

The Department of the Treasury and the Internal Revenue Service were extremely kind in issuing Revenue Procedure 2005-14.  It allows you to design an income tax and financial planning strategy to effectively deal with your highly appreciated primary residence when your capital gain significantly exceeds the tax free exclusion limitations of the 121 Exclusion. 

IRS Revenue Procedure 2005-14 allows you to convert your primary residence into investment property.  You accomplish this by moving out of your primary residence and converting and holding it as investment property, usually by renting it out for a period of time.  It is not clear how long you should rent your investment property in order to prove that you did in fact have the intent to hold it as investment property.  The majority of income tax advisors recommend at least 12 to 18 months in order to be safe. 

You can dispose of (sell) your property after you have held it as investment property and take advantage of the 121 Exclusion and the 1031 Exchange.  The first $250,000 or $500,000 would be tax free under Section 121 and the balance of the capital gain and depreciation recapture would be deferred by completing the 1031 Exchange.  Depreciation recapture income tax liabilities can not be excluded under Section 121, but certain depreciation recapture may be tax-deferred pursuant to Section 1031.

Examples from Revenue Procedure 2005-14

In each example below, the taxpayer is an unmarried individual and the property or a portion of the property has been used in the taxpayer's trade or business or held for investment within the meaning of Section 1031(a) as well as used as a principal residence as required under Section 121.

Example 1.

(i) Taxpayer A buys a house for $210,000 that A uses as A's principal residence from 2000 to 2004. From 2004 until 2006, A rents the house to tenants and claims depreciation deductions of $20,000. In 2006, A exchanges the house for $10,000 of cash and a townhouse with a fair market value of $460,000 that A intends to rent to tenants. A realizes gain of $280,000 on the exchange.

(ii) A's exchange of a principal residence that A rents for less than 3 years for a townhouse intended for rental and cash satisfies the requirements of both Sections 121 and 1031. Section 121 does not require the property to be the taxpayer's principal residence on the sale or exchange date. Because A owns and uses the house as A's principal residence for at least 2 years during the 5-year period prior to the exchange, A may exclude gain under Section 121. Because the house is investment property at the time of the exchange, A may defer gain under Section 1031.

(iii) Under Section 4.02(1) of this Revenue Procedure, A applies Section 121 to exclude $250,000 of the $280,000 gain before applying the nonrecognition rules of Section 1031. A may defer the remaining gain of $30,000, including the $20,000 gain attributable to depreciation, under Section 1031. See Section 4.02(2) of this Revenue Procedure. Although A receives $10,000 of cash (boot) in the exchange, A is not required to recognize gain because the boot is taken into account for purposes of Section 1031(b) only to the extent the boot exceeds the amount of excluded gain. See Section 4.02(3) of this Revenue Procedure.

These results are illustrated as follows:

            Amount realized                                                                      $470,000

            Less:  Adjusted basis                                                              $190,000

            Realized gain                                                                           $280,000

            Less:    Gain excluded under Section 121                                $250,000

                         Gain to be deferred                                                      $30,000

(iv) A's basis in the replacement property is $430,000, which is equal to the basis of the relinquished property at the time of the exchange ($190,000) increased by the gain excluded under Section 121 ($250,000), and reduced by the cash A receives ($10,000)). See Section 4.03 of this Revenue Procedure.

Example 2.

(i) Taxpayer B buys a property for $210,000. The property consists of two separate dwelling units (within the meaning of Section 1.121-1(e)(2)), a house and a guesthouse. From 2001 until 2006, B uses the house as B's principal residence and uses the guesthouse as an office in B's trade or business. Based on the square footage of the respective parts of the property, B allocates 2/3 of the basis of the property to the house and 1/3 to the guesthouse. In 2006, B exchanges the entire property for a residence and a separate property that B intends to use as an office. The total fair market value of B's replacement properties is $360,000. The fair market value of the replacement residence is $240,000 and the fair market value of the replacement business property is $120,000, which is equal to the fair market value of the relinquished business property. From 2001 to 2006, B claims depreciation deductions of $30,000 for the business use. B realizes gain of $180,000 on the exchange.

(ii) Under Section 121, B may exclude gain of $100,000 allocable to the residential portion of the house (2/3 of $360,000 amount realized, or $240,000, minus 2/3 of $210,000 basis, or $140,000) because B meets the ownership and use requirements for that portion of the property. Because the guesthouse is business property separate from the dwelling unit and B has not met the use requirements for the guesthouse, B may not exclude the gain allocable to the guesthouse under Section 1.121-1(e). However, because the fair market value of the replacement business property is equal to the fair market value of the relinquished business property and B receives no boot, B may defer the remaining gain of $80,000 (1/3 of $360,000 amount realized, or $120,000, minus $40,000 adjusted basis, which is 1/3 of $210,000 basis, or $70,000, adjusted by $30,000 depreciation) under Section 1031.

These results are illustrated as follows:

                                                                          Total           2/3 residential          1/3 business

                                                                       property             property                 property       

            Amount realized                                $360,000             $240,000               $120,000

            Basis                                                 $210,000             $140,000                 $70,000

            Depreciation adjustment                    $30,000                                              $30,000

            Adjusted basis                                  $180,000             $140,000                 $40,000

            Realized gain                                    $180,000             $100,000                 $80,000

            Gain excluded under Section 121     $100,000             $100,000

            Gain deferred under Section 1031      $80,000                                             $80,000

                                                                  

(iii) Because no portion of the gain attributable to the relinquished business property is excluded under Section 121 and B receives no boot and recognizes no gain or loss in the exchange, B's basis in the replacement business property is equal to B's basis in the relinquished business property at the time of the exchange ($40,000). B's basis in the replacement residential property is the fair market value of the replacement residential property at the time of the exchange ($240,000).

Example 3.

(i) Taxpayer C buys a property for $210,000. The property consists of a house that constitutes a single dwelling unit under Section 1.121-1(e)(2). From 2001 until 2006, C uses 2/3 of the house (by square footage) as C's principal residence and uses 1/3 of the house as an office in C's trade or business. In 2006, C exchanges the entire property for a residence and a separate property that C intends to use as an office in C's trade or business. The total fair market value of C's replacement properties is $360,000. The fair market value of the replacement residence is $240,000 and the fair market value of the replacement business property is $120,000, which is equal to the fair market value of the business portion of the relinquished property. From 2001 to 2006, C claims depreciation deductions of $30,000 for the business use. C realizes gain of $180,000 on the exchange.

(ii) Under Section 121, C may exclude the gain of $100,000 allocable to the residential portion of the house (2/3 of $360,000 amount realized, or $240,000, minus 2/3 of $210,000 basis, or $140,000) because C meets the ownership and use requirements for that portion of the property.

(iii) The remaining gain of $80,000 (1/3 of $360,000 amount realized, or $120,000, minus $40,000 adjusted basis, which is 1/3 of $210,000 basis, or $70,000, adjusted by $30,000 depreciation) is allocable to the business portion of the house (the office). Under Section 4.02(1) of this Revenue Procedure, C applies Section 121 before applying the nonrecognition rules of Section 1031. Under Section 1.121-1(e), C may exclude $50,000 of the gain allocable to the office because the office and residence are part of a single dwelling unit. C may not exclude that portion of the gain ($30,000) attributable to depreciation deductions, but may defer the remaining gain of $30,000 under Section 1031.

These results are illustrated as follows:

                                                                          Total           2/3 residential          1/3 business

                                                                       property             property                 property       

            Amount realized                                $360,000             $240,000               $120,000

            Basis                                                 $210,000             $140,000                 $70,000

            Depreciation adjustment                    $30,000                                             $30,000

            Adjusted basis                                  $180,000             $140,000                 $40,000

            Realized gain                                    $180,000             $100,000                 $80,000

            Gain excluded under Section 121     $150,000             $100,000                 $50,000

            Gain deferred under Section 1031      $30,000                                             $30,000

(iv) C's basis in the replacement residential property is the fair market value of the replacement residential property at the time of the exchange ($240,000). C's basis in the replacement business property is $90,000, which is equal to C's basis in the relinquished business property at the time of the exchange ($40,000), increased by the gain excluded under §121 attributable to the relinquished business property ($50,000). See Section 4.03 of this Revenue Procedure.

Example 4.

(i) The facts are the same as in Example 3 except that C also receives $10,000 of cash in the exchange and the fair market value of the replacement business property is $110,000, which is $10,000 less than the fair market value of the business portion of the relinquished property ($120,000).

(ii) Under Section 121, C may exclude the gain of $100,000 allocable to the residential portion of the house (2/3 of $360,000 amount realized, or $240,000, minus 2/3 of $210,000 basis, or $140,000).

(iii) The remaining gain of $80,000 (1/3 of $360,000 amount realized, or $120,000, minus $40,000 adjusted basis) is allocable to the business portion of the house. Under Section 4.02(1) of this Revenue Procedure, C applies Section 121 to exclude gain before applying the nonrecognition rules of Section 1031. Under §1.121-1(e), C may exclude $50,000 of the gain allocable to the business portion of the house but may not exclude the $30,000 of gain attributable to depreciation deductions. Under Section 4.02(2) of this Revenue Procedure, C may defer the $30,000 of gain under Section 1031. Although C receives $10,000 of cash (boot) in the exchange, C is not required to recognize gain because the boot is taken into account for purposes of Section 1031(b) only to the extent the boot exceeds the amount of excluded gain attributable to the relinquished business property. See 4.02(3) of this Revenue Procedure.

These results are illustrated as follows:

                                                                          Total           2/3 residential          1/3 business

                                                                       property             property                 property   

                                                                      $110,000 +

Amount realized                                  $360,000            $240,000                  $10,000

Basis                                                   $210,000            $140,000                  $70,000

Depreciation adjustment                      $30,000                                              $30,000

Adjusted basis                                    $180,000            $140,000                  $40,000

Realized gain                                      $180,000            $100,000                  $80,000

Gain excluded under Section 121       $150,000            $100,000                  $50,000

Gain deferred under Section 1031       $30,000                                              $30,000

(iv) C's basis in the replacement residential property is the fair market value of the replacement residential property at the time of the exchange ($240,000). C's basis in the replacement business property is $80,000, which is equal to C's basis in the relinquished business property ($40,000), increased by the gain excluded under Section 121 ($50,000), and reduced by the cash ($10,000) received. See Section 4.03 of this Revenue Procedure.

Example 5.

(i) The facts are the same as in Example 3 except that the total fair market value of the replacement properties is $540,000. The fair market value of the replacement residence is $360,000, the fair market value of the replacement business property is $180,000, and C realizes gain of $360,000 on the exchange.

(ii) Under Section 121, C may exclude the gain of $220,000 allocable to the residential portion of the house (2/3 of $540,000 amount realized, or $360,000, minus 2/3 of $210,000 basis, or $140,000).

(iii) The remaining gain of $140,000 (1/3 of $540,000 amount realized, or $180,000, minus $40,000 adjusted basis) is allocable to the business portion of the house. Under Section 4.02(1) of this Revenue Procedure, C excludes the gain before applying the nonrecognition rules of §1031. Under Section 1.121-1(e), C may exclude $30,000 of the gain allocable to the business portion, at which point C will have excluded the maximum limitation amount of $250,000. C may defer the remaining gain of $110,000 ($140,000 realized gain minus the $30,000 gain excluded under Section 121), including the $30,000 gain attributable to depreciation, under Section 1031.

These results are illustrated as follows:

                                                                          Total           2/3 residential          1/3 business

                                                                       property             property                 property    

Amount realized                                  $540,000            $360,000               $180,000

Basis                                                   $210,000            $140,000                 $70,000

Depreciation adjustment                      $30,000                                            $30,000

Adjusted basis                                    $180,000            $140,000                $40,000

Realized gain                                      $360,000            $220,000                $30,000

Gain excluded under Section 121       $250,000            $220,000                $30,000

Gain deferred under Section 1031      $110,000                                         $110,000

(iv) C's basis in the replacement residential property is the fair market value of the replacement residential property at the time of the exchange ($360,000). C's basis in the replacement business property is $70,000, which is equal to C's basis in the relinquished business property ($40,000), increased by the amount of the gain excluded under Section 121 ($30,000). See Section 4.03 of this Revenue Procedure.

Example 6.

(i) The facts are the same as in Example 3 except that the total fair market value of the replacement properties is $750,000. The fair market value of the replacement residence is $500,000, the fair market value of the replacement business property is $250,000, and C realizes gain of $570,000 on the exchange.

(ii) The gain allocable to the residential portion is $360,000 (2/3 of $750,000 amount realized, or $500,000, minus 2/3 of $210,000 basis, or $140,000). C may exclude gain of $250,000 from gross income under Section 121. C must include in income the gain of $110,000 allocable to the residential portion that exceeds the §121(b) exclusion limitation amount.

(iii) The remaining gain of $210,000 (1/3 of $750,000 amount realized, or $250,000, minus $40,000 adjusted basis) is allocable to the business portion of the house. C may defer the $210,000 of gain, including the $30,000 gain attributable to depreciation, under Section 1031.

These results are illustrated as follows:

                                                                          Total           2/3 residential          1/3 business

                                                                       property             property                 property      

Amount realized                                  $750,000            $500,000               $250,000

Basis                                                    $210,000           $140,000                 $70,000

Depreciation adjustment                       $30,000                                           $30,000

Adjusted basis                                     $180,000           $140,000                $40,000

Realized gain                                       $570,000           $360,000               $210,000

Gain excluded under Section 121        $250,000           $250,000

Gain deferred under Section 1031       $210,000                                         $210,000

Gain recognized                                   $110,000           $110,000

 

(iv) C's basis in the replacement residential property is the fair market value of the replacement residential property at the time of the exchange ($500,000). C's basis in the replacement business property is $40,000, which is equal to C's basis in the relinquished business property at the time of the exchange.

Revenue Procedure Retroactive

Revenue Procedure 2005-14 is effective January 27, 2005, but can be applied by Taxpayers to taxable years for which the period of limitations for refunds or credits have not expired pursuant to Section 6511.

Tax, Legal and Financial Advisors

This is a tremendous tax and financial planning opportunity that many taxpayers should take advantage of.  However, taxpayers should only structure these transactions after consulting with competent tax, legal and financial advisors.

END OF ARTICLE

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