If you own real estate that has been used as both a residence and a rental or investment property, when it comes time to sell, you may have the opportunity to maximize your tax advantages by combining a 1031 exchange with a Section 121 exclusion. This income tax and financial planning strategy can be beneficial when dealing with highly appreciated property that has capital gains in excess of the limitations of a 121 exclusion.
The following guide provides a brief overview of each of these tax provisions and discusses some scenarios that allow you to take advantage of both simultaneously.
1031 Exchange
A 1031 exchange is a tax provision that allows you to defer federal and state capital gains taxes and depreciation recapture when selling an investment property and using the proceeds to purchase a “like-kind” replacement property. This is often attractive to real estate investors who want to grow their portfolios, as 1031 exchanges can be repeated indefinitely.
To receive these tax benefits, investors must follow a strict set of rules. This includes the 45-day rule, which requires you to identify one or more replacement properties in writing within 45 calendar days of the sale of the relinquished property, and the 180-day rule, which requires you to close on one or more of the identified properties within 180 days of the sale of the relinquished property.
A 1031 exchange also requires the use of a qualified intermediary (QI), who takes possession of the sale proceeds and facilitates the purchase of the replacement property. The IRS rarely grants exceptions to these rules. Failure to use a QI or meet the deadlines will almost always result in a failed exchange and a significant tax liability.
In addition to meeting the 1031 exchange rules, both properties must also be “held for investment purposes or for use in a trade or business” to qualify for this favorable tax treatment. While this generally excludes an individual’s primary residence, there are a few situations that allow a residence to qualify for a 1031 exchange. We’ll discuss this in detail in just a moment.
Section 121 Exclusion
A Section 121 exclusion allows homeowners to exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains taxes on the sale of their primary residence, as long as they meet the following requirements:
- The taxpayer must have occupied the home for at least two of the five years prior to the home sale (the 24 months do not have to be consecutive)
- The taxpayer must not have claimed a Section 121 exclusion within the past two years
A Section 121 exclusion applies exclusively to a taxpayer’s primary residence. It cannot be used for the sale of a rental property or a vacation home.
Combining a 1031 Exchange with a 121 Exclusion
Since a 1031 exchange can only be used with investment properties and a Section 121 exclusion can only be used with a primary residence, you may assume that they cannot be combined. However, there are a few situations that would allow you to claim both on the same property sale.
Primary Residence Converted to a Rental Property
When you convert your primary residence into a rental property, you may qualify for both tax breaks if you meet certain requirements. First, you must have lived in the home for at least 24 months during the five years prior to the sale. This would qualify the property for a Section 121 exclusion.
Then, once you’ve converted the home into a rental property, it should qualify for a 1031 exchange as long as you can prove the property was held for investment purposes. While 1031 exchange rules do not specify a required holding period, the IRS has stated that a 24-month hold period is sufficient.
Revenue Procedure 2008-16 also provides a safe harbor for 1031 exchanges. It states that your intention to use a property for investment purposes will not be challenged if it is rented out at fair market price for at least 14 overnights during each of the years it was held as an investment property (or 10% of the annual overnights if you’ve personally spent more than 14 overnights there during the same time period). Note that personal overnights include time that family and friends stayed in the home without paying rent at the fair market price).
Rental Property Converted to a Primary Residence
The second scenario applies to rental properties that were purchased using a 1031 exchange. This would allow you to defer the capital gains taxes and depreciation recapture on the sale of the relinquished property. Just like the scenario above, you would generally want to hold the property for investment purposes for at least 24 months to avoid having the exchange disqualified.
Once you’ve met this initial requirement, you could move into the property and use it as your primary residence. After you’ve lived there for at least 24 months, you would have met the residency requirement for a Section 121 exclusion. If you hold the property for at least five years before selling it, you could claim a Section 121 exclusion on the sale, as long as you have not claimed another Section 121 exclusion within the two years prior.
Investment Property Converted to a Primary Residence
The final scenario involves purchasing an investment property and later converting it into your primary residence. Again, to qualify for a Section 121 exclusion, you would need to live in the home for 24 months during the five-year period before the property sale. As a reminder, these 24 months do not have to be consecutive.
Once you’ve met this two-year rule, you would have the option to decide whether to use the property as the first part of a 1031 exchange or sell it outright and take the Section 121 exclusion.
The Bottom Line
Taking advantage of both a 1031 exchange and a Section 121 exclusion typically requires advanced planning. It’s recommended that you work with an experienced tax professional, a qualified intermediary, and other financial professionals to help ensure the proper execution of your strategy.
If you would like to explore your options, a member of our team would be happy to assist. Contact us to schedule a consultation.
Your Comments :