Mackay, Caswell & Callahan, P.C.
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Guidance for Utilizing Sections 121 & 1031 in Combination

May 31st 2018
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Virtually all CPAs, tax attorneys and other tax professionals will bring the Principal Residence Exclusion under Section 121 of the IRC to the attention of their clients at some point in their careers. Likewise, there is an equal probability that tax professionals will suggest that at least one of their clients conduct a tax-deferred exchange under Section 1031.

Both of these sections are among the most financially beneficial provisions of the tax code. Just by themselves, each of these sections has the potential to save taxpayers hundreds of thousands – and even millions, if Section 121 be used repeatedly – of dollars in taxes.

Section 121 refers specifically to personal residences, while Section 1031 refers to real property held for investment or business purposes. Previously, Section 1031 could be applied to personal property held for business or investment, but this application was recently removed with the Tax Cuts & Jobs Act. While these sections are undoubtedly powerful when used separately, when used together in combination they can be even more useful for taxpayers.

Tax professionals of all kinds – Philadelphia CPAs, Los Angeles tax advisors, Albany tax attorneys, and so forth all across the nation – should understand the rules for utilizing these two sections together so that they can better serve their clients and help them maximize their financial condition.

Converting Property Before the Sale

Section 121 allows individual taxpayers to eliminate up to $250,000, and married taxpayers (filing jointly) to eliminate up to $500,000, of gain from the sale of a “principal residence” (or “primary residence”). To qualify as a principal residence, taxpayers must own and reside in the property for at least 2 years out of the most recent 5 year period. These 2 years do not have to run consecutively, and so it’s possible for a taxpayer to reside in a property for 1 year, live elsewhere for 3 years, go back and reside in the property for another year and then sell the property using the benefits of Section 121.

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By bhernon
Jul 24th 2019 01:19

My client's CPA and 1031 intermediary are at odds with combining 1031 exchange and a 121 exclusion. Can you help clarify? A case history would be ideal. ;-)

The property was a principle residence for husband and wife for many years. It then became a rental property of the couple for two years. It recently sold for $1.4M. Net proceeds from the sale will be around $700k in cash after paying off $600k in debt and $100K in taxes and transaction costs.

The CPA says take the $500k 121 exclusion out of net proceeds and deliver $200k to the 1031 intermediary. The client than has to the buy $700k of new property and use all $200k of cash to qualify for 100% deferral of the capital gains portion of the sale.

The 1031 intermediary says take the $500k 121 exclusion out of the sale price of $1.4M. He then has to buy $900K of new property, and use whatever cash is left over in the new purchase to qualify for 100% deferral of the capital gains portion of the sale. No cash can go into personal account, not even any part of the 121 exclusion money.

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Replying to bhernon:
Jorgen
By Jorgen Rex Olson
Jul 24th 2019 03:04

I’d need to know the adjusted basis of the property to give a full response, but unless the gain is less than the exclusion, my answer is that the target price for the replacement property will be 800k. The 100k closing costs can be taken from the $1.4M proceeds, that’s fine, but then the 500k exclusion would bring the proceeds to 800k. The exclusion means that the cash (gain) from the proceeds isn’t counted in the gross income of the taxpayer. So after paying off the 600k debt, the taxpayer would need to buy a replacement property with a minimal sales price of 800k to reacquire enough debt and defer whatever capital gains are remaining. The intermediary is incorrect, because as long as the closing costs of 100k are allowable, they can be paid with exchange proceeds without any tax consequences.

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Replying to Jorgen Rex Olson:
avatar
By bhernon
Jul 24th 2019 03:56

I may not have been clear, as I was rounding. Cash and Gain are not the same thing. Maybe this example is too close between the two to tell the difference.

Cash is what sits in the escrow account after settlement.
Gain is the difference between cost basis and net proceeds.

(in thousands)
1,455 Sale price
590 purchase price
32 Improvements
145 Selling Costs
=====
688 Gain

1,455 Sale price
145 Selling Costs
600 Loan Payoff
=====
710 Cash

The intermediary says all the $710K of cash must be used in the new property acquisition.

The CPA says go ahead and take out $500K in cash and only $210 of cash is needed for the new property acquisition.

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Replying to bhernon:
Jorgen
By Jorgen Rex Olson
Jul 24th 2019 05:06

Yes this is clearer. I believe the CPA is correct. The 500k cash can be taken out. This is treated as gain, but is excludable (so tax free under 121), and so there would be 188k of gain left to defer. This can be deferred by spending the remaining cash of 210k and obtaining a loan of equal amount. Any additional cash received would be cash boot, taxable to the extent of the gain, and any reduction in loan would be considered debt relief (or mortgage boot), also taxable to the extent of the gain.

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