Many homeowners are familiar with the personal residence gain exclusion [Internal Revenue Code (IRC) Section 121] which allows taxpayers filing a federal income tax return to exclude from gross income certain realized capital gains when selling their primary residence. Under this tax provision, $500,000 of capital gains can be excluded every two years for taxpayers married filing a joint return ($250,000 for single) provided:
- the property is their principal residence and
- the taxpayer has lived in the property for at least two of the last five years.
However, homeowners who have lived in their house for many years and have experienced substantial appreciation, wonder what options may be available when considering the disposition of their primary residence where capital gains would exceed the allowable personal residence gain exclusion.
One option may be to consider the application of IRC 1031 (like-kind exchange or 1031 Exchange) along with IRC 121. The Internal Revenue Service (IRS) has issued guidance (Rev. Proc. 2005-14) for taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the exchange of a principal residence under IRC 121 and the non-recognition of gain on the exchange of like-kind property under IRC 1031. This guidance states and illustrates that the provisions of IRC 121 must be applied to the gain realized before the application of IRC 1031.
Basically, under a 1031 Exchange, gain or loss realized is not recognized but rather deferred on the exchange of like-kind property. Like-kind property is real property for real property (e.g., a house for a duplex; a house for land, etc.…) or sometimes seen in business transactions the exchange of personal property for personal property.
In general, the provisions of IRC 1031 apply to property held for investment or productive use in a trade or business, but such property cannot be personal-use property or inventory/stock in trade of a business.
Looking back at the requirements above for the personal residence gain exclusion, a taxpayer must have lived in the home for two of the last five years. So if, after living in the home for more than two years, the homeowner then converts their home into investment property by renting the house for one to just less than three years (Caveat: do not miss the personal-use requirement of two of the last five years), the rental activity use then qualifies the house as property held for investment (rather than personal-use property) for purposes of the 1031 Exchange rules.
Let’s look at an example to illustrate the required ordering of the rules and related requirements:
FACTS: Mr. and Mrs. Lee (Taxpayers) purchased their principal residence in Hawaii for $210,000 many years ago. Their home is now worth $750,000. Taxpayers move out and rent their old house for two years and claim $8,000 in depreciation deductions.
Taxpayers then exchange their old house for $100,000 in cash (“boot”) and a townhouse with a fair market value of $650,000, which will be rented to new tenants. Taxpayers realize $548,000 [($100,000 + $650,000 = $750,000 = amount realized) minus (210,000 – 8,000 = 202,000 = adjusted tax basis of the house)] of gain on their exchange.
Now let’s look at the results for the application of the rules to see how much gain, if any, Mr. and Mrs. Lee are required to report on there income tax return when they dispose of their old house.
RESULTS: Mr. and Mrs. Lee transfer their old home that they rented for two year in exchange for cash and a townhouse to be rented – this satisfies the requirements of both IRC 121 and 1031. Here it’s noted that the personal residence gain exclusion rules do not require the house to be used as the Taxpayer’s principal residence at the time of disposition. Because Mr. and Mrs. Lee owned and used the house as their principal residence for at least two years during the 5-year period prior to the exchange, they are eligible to exclude gain under IRC 121. Because the house is investment property used in a rental activity at the time of the exchange, Taxpayers are also eligible to defer gain under IRC 1031.
Mr. and Mrs. Lee first apply IRC 121 to exclude $500,000 of the $548,000 gain realized before applying the 1031 Exchange rules. Mr. and Mrs. Lee then defer the remaining gain of $48,000 (including the $8,000 gain attributable to rental depreciation) under the like-kind exchange rules. Although Mr. and Mrs. Lee received $100,000 cash/boot in the exchange, they are not required to report gain since the boot (for IRC 1031 purposes) is taken into account only to the extent that it exceeds the amount of the gain excluded under IRC 121.
Mr. and Mrs. Lee’s tax basis in their new town home held for rental (the replacement property) is $602,000, which is equal to their carryover adjusted tax basis ($202,000) of the old house relinquished at the time of the exchange increased by the personal residence gain excluded ($500,000) under IRC 121, and reduced by the cash ($100,000) they received. Said another way, their new town home worth $650,000 has a tax basis of $602,000, which reflects the built-in deferred gain of $48,000.
In this example, the combined application of the personal residence gain exclusion and the like-kind exchange rules results in no taxable gain for Mr. and Mrs. Lee in the year of the exchange and $48,000 gain deferred to a future tax year when the town home is eventually sold.
Then, if desired, after two or more years, (per IRS safe harbor rules), the replacement property (Mr. and Mrs. Lee’s town home) acquired through a 1031 Exchange can be converted into a principal residence. [NOTE: For this and other real estate transactions, additional tax rules and restrictions may apply. The tax laws and regulations are very complex — please consult your tax advisor].