1031 Tax Deferred Exchange
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  IRS Eases Rules Combining 1031 and Section 121  

IRS Eases Rules for Combining Home Sale Exclusions and 1031 Exchanges


The 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.

Section 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.

For 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.

Here 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.

Your 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.

Example 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.

As 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.

So, 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 Table 1.

Two 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.

This 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.

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