Author: Betsy Glaeser | Tax Senior Associate
Now that residential real estate markets are on the road to recovery, many principal residences once again have fair market values in excess of cost. If sold, some of these homes would trigger significant gains. Despite the upside of recovering markets and large home sale profits, many taxpayers would face undesirable tax liabilities due to higher capital gains tax rates and exposure to the Net Investment Income Tax. One technique to avoid such a tax bill is to combine the Section 121 exclusion provision with the tax-deferral advantage of a Section 1031 like-exchange. According to Revenue Procedure 2005-14, if properly executed, this can be done with full IRS approval.
Section 121 provides that a taxpayer can exclude gain realized on the sale or exchange of property if the property was owned and used as the taxpayer’s principal residence for 2 years during the 5-year period ending on the date of the sale or exchange. Section 121 allows a gain exclusion of $250,000 for single taxpayers and $500,000 for certain married taxpayers filing jointly. Section 1031(a) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment.
To accomplish a favorable outcome, taxpayers must arrange property exchanges that satisfy the requirements of both Sections, with the Section 121 exclusion being applied before the Section 1031 gain-deferral. Taxpayers must show that their former principal residence has been converted to property “held for productive use in a trade or business or for investment.” The safe-harbor established in Revenue Procedure 2008-16 indicates that such a conversion works after two years. If the taxpayer receives boot (cash or property that is not like kind property) in the exchange, it triggers taxable gain only to the extent the boot exceeds the amount of gain that is excluded under the Section 121 exclusion rules. It should also be noted that the Section 121 gain exclusion does not apply to gain attributable to depreciation deductions for periods after May 6, 1997, claimed with respect to the business or investment portion of a residence; however, Section 1031 may apply to such a gain.
In determining the basis of the property received in the exchange to be used in the taxpayer’s trade or business or held for investment (the replacement property), any gain excluded under the Section 121 rules is treated as gain recognized by the taxpayer. Therefore, the basis of the replacement property is effectively increased by the amount of the gain excluded under the Section 121 rules, even though tax was not paid on that gain (Section 1031(d)).
Revenue Procedure 2005-14 includes examples that illustrate how the rules work. Below is an adaptation of one example:
David (unmarried) purchased a house for $230,000 that he used as his principal residence during 2009 to 2011 (three full years). During 2012 and 2013, David rented his home and claimed depreciation deductions of $20,000. In 2014, he exchanged the house (relinquished property) for $10,000 of cash and a house with a fair market value of
$600,000 (replacement property). David intends to rent the new house, not live in it as his principal residence. David realizes a gain of $400,000 on the exchange:
Proceeds $610,000 [$600,000 FMV + $10,000 cash boot]
Basis in relinquished property ($210,000) [$230,000 cost – $20,000 depreciation]
Realized gain $400,000
Given David’s facts, under Revenue Procedure 2005-14 the exchange of David’s former residence for a house that he intends to use as a rental property satisfies the requirements of both Section 121 and 1031. David first applies Section 121 to exclude $250,000 of his
$400,000 realized gain. Then, David applies the Section 1031 non-recognition rules. Although he received $10,000 of boot in the exchange, under Section 1031(b) David does not recognize any taxable gain because boot is taken into account only to the extent that it exceeds the gain excluded under Section 121 ($250,000 in this case). As such, under Section 1031, David will defer a gain of $150,000 (total realized gain of $400,000 – Section
121 excluded gain of $250,000). David’s basis in the new rental house is $450,000:
|Basis of relinquished property||$210,000|
|Gain excluded under Sec. 121||$250,000|
These concepts can also be applied to a former residence that has a separate dwelling unit used for business. For example, Steven and Natalie (married filing jointly) purchased a property that consisted of two separate dwelling units: a main house and a guesthouse. From 2009 to 2013, Steven and Natalie used the main house as their principal residence, while Natalie used the guesthouse as an office for her single-member LLC business. Based on the relative square footage of the two dwellings, Steven and Natalie allocated 2/3 of the property’s basis to the main house and 1/3 to the guesthouse. In 2014, Steven and Natalie plan to exchange the entire property for a residence and a separate property that Natalie intends to use as an office. Because the guesthouse was a separate dwelling unit and was used exclusively as business property, it will not qualify for the Section 121 exclusion. However, the exchange of the relinquished office for the replacement office will qualify for gain deferral under Section 1031, including the gain attributable to depreciation (recapture). Under Section 121, Steven and Natalie will exclude the portion of the gain allocable to the residential portion of the relinquished property, generally up to $500,000.
Under the right conditions, coupling the Section 121 exclusion provision and the Section 1031 gain deferral provision can save taxpayer’s a significant amount of tax. In order to successfully exclude and defer gains, proper planning is critical to ensure that the requirements for both Sections are satisfied.
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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.