For quite some time, the interaction of §121 (exclusion of gain on the sale of a principle residence) and §1031 (non-recognition of gain or loss in like-kind exchanges) has confused many taxpayers. Fortunately, the Internal Revenue Service has provided clear guidance on this matter with Revenue Procedure 2005-14.
In order for Revenue Procedure 2005-14, which was issued February 14, 2005, to be effective, taxpayers must “exchange property that satisfies the requirements for both the exclusion of gain from the exchange of a principal residence under § 121 and the nonrecognition of gain on the exchange of like-kind properties under § 1031.” Moreover, the Revenue Procedure applies only to taxpayers who satisfy the ‘held for productive use in a trade or business or for investment’ requirement of § 1031(a)(1) with respect to both the relinquished business property and the replacement business property.
Since neither §121 nor §1031 addresses the application of both sections to the exchange of a single piece of property, this Revenue Procedure was necessary to provide guidance to taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the exchange of a principal residence under § 121 and the nonrecognition of gain on the exchange of like-kind properties under § 1031.
Provisions of Section 121:
- A taxpayer may exclude gain realized on the sale or exchange of property, if the property was owned and used as the taxpayer’s principal residence for at least two (2) of the preceding five (5) years.
- Generally, the amount of the exclusion is limited to $250,000 ($500,000 for certain joint returns).
- As amended by the American Jobs Creation Act of 2004, Pub. L. 108-357, provides that, for sales or exchanges commenced after October 22, 2004, taxpayers who acquired property in an exchange to which § 1031 applied, must hold the property for five years from the acquisition date before they may apply the § 121 exclusion.
Provisions of Section 1031:
- No gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment (relinquished property) if the property is exchanged solely for property of like kind (replacement property) that is to be held either for productive use in a trade or business or for investment.
- Under § 1031(b), gain must be recognized, however, to the extent that the taxpayer also receives cash or property that is not like-kind property (boot) in an exchange that otherwise qualifies under § 1031(a).
In order to garner the benefits of both §121 and §1031, taxpayers must adhere to these new rules:
(1) Application of § 121 before § 1031. Section 121 must be applied to gain realized before applying § 1031
(2) Application of § 1031 to gain attributable to depreciation. Under § 121(d)(6), the § 121 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, § 1031 may apply to such gain; and
(3) Treatment of boot. In applying § 1031, cash or other non-like kind property (boot) received in exchange for property used in the taxpayer’s trade or business or held for investment (the relinquished business property), is taken into account only to the extent the boot exceeds the gain excluded under § 121 with respect to the relinquished business property.
As an example of the Revenue Procedure, let’s assume an unmarried individual (Taxpayer A) buys a house for $210,000. This house is Taxpayer A’s principal residence from 2000 to 2004. Let us further assume that during the same period (2004 to 2006), Taxpayer A rents the house to tenants and claims depreciation deductions of $20,000. In 2006, Taxpayer A decides to exchange the house for $10,000 of cash and a townhouse with a fair market value of $460,000 that Taxpayer A intends to rent to tenants. At the time of the exchange, Taxpayer A had an adjusted basis in the property of $190,000, and realizes a gain of $280,000 on the exchange.
Since the property was a principal residence that was rented for less than three (3) years and exchanged for a townhouse intended for rental and cash the requirements of both §§ 121 and 1031 have been satisfied. According to Section 121, the property must be used for at least two (2) of the preceding five (5) years, and does not require the property to be the taxpayer’s principal residence on the sale or exchange date. As a result, Taxpayer A may exclude a portion of the gain under § 121. Because the house is investment property at the time of the exchange, Taxpayer A may also defer a portion of the gain under § 1031.
Under the guidelines of Revenue Procedure 2005-14, Taxpayer A must first apply § 121 to exclude $250,000 of the $280,000 gain ($280,000 minus $20,000 depreciation, minus $10,000 cash received) before applying the non-recognition rules of § 1031. Taxpayer A may then defer the remaining gain of $30,000, including the $20,000 gain attributable to depreciation, under § 1031. While Taxpayer A received $10,000 of cash (boot) in the exchange, there is no need to recognize the gain because the boot is taken into account for purposes of § 1031(b) only to the extent the boot exceeds the amount of excluded gain.
Taxpayer A’s basis in the replacement property was $430,000, which is equal to the basis of the relinquished property ($190,000) at the time of the exchange, increased by the gain ($250,000) excluded under § 121, and reduced by the cash Taxpayer A receives ($10,000).
While the Internal Revenue Service has clarified many of the issues surrounding the interaction of these two Sections, the interaction of §121 and §1031 is not for the faint of heart. The underlying vagaries of §1031 and the gauntlet of regulations, revenue rulings, and cases requires careful planning and attention be employed in all like-kind exchanges.
IRC Section 1031 allows taxpayers to defer the gain on the disposition of business or investment real estate, if that real estate is replaced with like-kind real estate, within specific timeframes. Consult your tax or legal advisor for additional information on the requirements and limitations of such exchanges. Wilmington Trust 1031 Exchange LLC is a wholly owned subsidiary of Wilmington Trust, N.A. *Wilmington Trust 1031 Exchange LLC does not provide tax or legal advice to clients. Wilmington Trust does not provide tax, legal, or accounting advice. Please consult professionals in those areas before making any decisions.