IRS recently issued a ruling further explaining the handling of
real estate transactions involving both personal residences and
investment property. Under this new ruling, your exclusion from
capital gains tax can be maximized in transactions that involve
both types of properties. Depending on the situation, the IRS
will now allow you to use your entire exclusion for your personal
residence. If you have any gain left over (above the maximum exclusions),
then you can defer it through a tax-deferred exchange!
IRS code Section 121 lets you exclude $250,000 of gain if you
file a single-return and up to $500,000 excluded if you file a
joint-return when you sell your personal residence if you have lived there for two of the last five years.
IRS code Section 1031 applies to investment property and allows you to roll the gain from your Old Investment Property to your New Investment Property
-- thereby defer paying the capital gains taxes. Remember, this
is property you hold for investment or for business use.
1031 applies to investment property, and Section 121 applies to
your residence. What about property that is, or was both your
residence and used for investment...? Since Section 121 applies
if the property has been your residence for any two of the last
five years -- this raises the question of what was it the other
three years? (Assuming that you don't live in the property
any more...) The obvious answer is that it was investment property,
and that is where Section 121 and Section 1031 overlap.
the last seven or eight years we've been writing articles and
teaching classes about this overlap of the two tax code sections.
Now there's an IRS ruling that verifies what we've been teaching.
What the ruling effectively says is that when you have real estate
that is a possible Section 121/1031 overlap, you get to maximize
the tax free exclusion of Section 121 first, and then apply the
remainder to Section 1031 exchange.
are two examples of how this new rule works. Fred and Sue are
selling a house that they lived in for 24 months (years one and
two). During years three and four they rented the house out (and
lived somewhere else). Now Fred and Sue are selling the house
at a gain of $600,000. How much of this gain is tax free under
Section 121 and how much is rollover gain under Section 1031?
Notice that the property was their residence half of the time, and was rental property the other half.
inclination would be to treat half the gain (just
$300,000) as tax free under Section 121, and to roll the other
half over via Section 1031. But under the new ruling you first
apply as much of the gain as you need to maximize the Section
121 gain, with the balance applied to the Section 1031 gain. So
in this case (Fred and Sue file a joint-return) that means that
the gain to be excluded under Section 121 is $500,000! And the
remaining $100,000 of gain could then be deferred using Section
1031 by doing an exchange.
Two: Fred and Sue have a one story house with a walk-out basement.
They live up stairs, and the basement is their office. Their CPA
has treated their office as half of the structure (with their
residence being the other half). Again, they are selling their
house at a gain of $600,000.
in the above example, you first apply as much gain as necessary
to maximize your Section 121 exclusion ($500,000), with the balance
($100,000) applied to the Section 1031 gain.
whether the property is currently both your residence and your
office, or if the property was fully your residence for two years
and then used for investment for the other time, you need to first
fully allocate the appropriate gain as your personal residence,
then you can apply any remaining gain to an exchange. In both
of our examples, the schedule allocating the gain would look like
last things we want to bring to your attention: (1) You must recapture
the depreciation you have taken after May of 1997; and (2) In
our discussion above we assumed that you would roll over the remaining
gain from these examples using Section 1031. In fact, you may
decide not to do an exchange and therefore must treat the remaining
$100,000 gain as recognized and pay taxes on it.
new ruling is a great gift from the government to every taxpayer
who has property that is part personal residence and part investment
-- whether it's because you have an office in your home, or because
you've treated it as both an investment and as your primary residence
over the last five years.