Have a Home and Exchange It, Too

Many people are making significant gains in today’s hot real estate market. They are also creating significant tax burdens for themselves. Two popular methods for reducing or eliminating these tax burdens are Section 121, the Home Sale Exclusion, and Section 1031, Like Exchange break.

Section 121 allows a taxpayer to exclude gains (up to $250,000 individual or $500,000 married couple) realized on the sale or exchange of property owned and used as the taxpayer’s principal residence for at least two of the five years prior to the sale or exchange. If a portion of the property is used for residential purposes and a portion is used for business purposes, the entire property is treated as a personal residence toward satisfying the Section’s two-year residency requirement. The American Jobs Creation Act of 2004, however, amended Section 121 so that the principal home exclusion would not apply if the property was acquired in a Section 1031 exchange during the five-year period from the date of the property’s acquisition. The amended provision affects sales or exchanges occurring after October 22, 2004.

Section 1031 provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment purposes if the property is exchanged for property of a like kind for the same kind of use. Cash or property that is not of like kind received in an exchange otherwise qualifying for Section 1031 the gain must be recognized. Property used solely as a personal residence is excluded from Section 1031.

In some cases, both Section 121 and Section 1031 may apply to an exchange. Unfortunately, neither Section addresses how to apply both provisions to a single property exchange. The Internal Revenue Service (IRS) offers the following guidance for applying both Section 121 and Section 1031:

  • Apply Section 121 to any gain first, before applying Section 1031.
  • Section 121 does not apply to gains that can be attributed to depreciation deductions on the business or investment portion of a residence after May 6, 1997. Section 1031 may apply.
  • Section 1031 applies only to the gain to the extent it exceeds the amount excluded under Section 121 with respect to the relinquished business property.
  • Under Section 1031, the basis of the replacement property is increased by any gain attributable to the relinquished business property excluded in Section 121. The gain excluded under Section 121 is treated as gain recognized by the taxpayer.

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