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

May 31st 2018
Mackay, Caswell & Callahan, P.C.
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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.

If you have a client who wants to combine these sections prior to the sale, he or she will have to establish the property as his or her personal residence and then convert the property into an investment vehicle. This means that your client will need to satisfy the time requirement of Section 121 and the holding requirement of Section 1031.

Section 1031 is only eligible for real property “held for” productive use in trade or business or for investment. Unlike with Section 121, this holding requirement is not strictly a time requirement, but is based on the intent of the taxpayer, and intent is established by considering all relevant facts and circumstances surrounding the taxpayer’s ownership of the property.

Here’s how a transaction involving both 121 and 1031 before the sale might proceed:

  • your client acquires a property, moves in and resides for 2 years, and then exits and converts the property into a rental 
  • your client then holds the property for investment for 18 months, being very careful to treat it just as he or she would treat any other piece of investment property
  • your client then sells the rental property and is able to utilize the exclusion provided by Section 121 and also the tax deferral benefits provided by Section 1031

Utilizing 121 & 1031 in an Allocation

Sections 121 and 1031 may also be combined in cases involving partial personal use of an investment property. You may have a client who approaches you who currently resides in only a portion of his or her investment property. For instance, you may have a client who owns a multi-unit rental complex – say a complex with 4 units – and resides in 1 of the units and rents out the remaining 3 to unrelated renters. In this scenario, your client would be able to utilize both sections, just as in the example given above, but he or she would need to “allocate” the portion used as a personal residence when conducting a 1031 exchange.

Suppose that your client’s 4 unit complex has a sales price of $1 million. In this case, the taxpayer would allocate the personal residence portion and invoke Section 121 to eliminate the gain associated with that portion rather than the entire complex. In other words, only the gain realized from the personal residence portion would be eligible for exclusion under Section 121, whereas the remaining proceeds from the other 3 units would need to go toward replacement property under Section 1031.

Converting Property After the Sale

The rules for using these sections in combination after the completion of a Section 1031 exchange are a bit more involved and so you will need counsel your clients accordingly. After completing an exchange, taxpayers may convert their replacement property into a personal residence and then take advantage of Section 121 to eliminate some (or all, depending on the situation) of the gain.

However, in this scenario, taxpayers must own the replacement property for a minimum of 5 years following the exchange transaction; this is true even though taxpayers still only need to use the property as a personal residence for 2 years to satisfy the use requirement of Section 121. After owning the property for at least 5 years, and using it for at least 2 years during this time period, taxpayers may sell the property used in the exchange and utilize Section 121.

But, in the case of a post-exchange conversion, the time that the taxpayer uses the property as a personal residence figures what amount of the gain is eligible for exclusion. The rule works like this: the amount of time during which the property is used for investment purposes is considered “non-qualifying use” for Section 121, and so that amount of time cannot be used toward the exclusion; taxpayers will put the amount of non-qualifying use in a fraction as the numerator, and the total number of years that the property is owned will be put as the denominator.

The fraction which shows up represents the portion of the realized gain which is not excludable under Section 121. Here’s an example:

your client finishes a like-kind exchange and then owns the property for a total of 8 years after the transaction

your client rents out the property for just 2 years following the exchange, and then moves in and establishes the property as his personal residence for the next 6 years.

He then decides to sell the property and wants to use Section 121.

In this scenario, 2/8 of the gain (or ¼) would be considered not excludable under the principal residence exclusion because that would represent the non-qualifying use period during which the property was used for investment.

It’s important to remember that the holding requirement still applies on this post-sale side of the transaction, and so practitioners should be sure to counsel their clients about the risks associated with converting their property into a personal residence prematurely. If taxpayers do not satisfy the holding requirement on the post-sale side, they run the risk of having the underlying 1031 exchange transaction nullified by the IRS.

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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:
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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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