1031 Exchange Evolution: Using Section 121 and Section 1031 Together
One example of the way the tax law continues to evolve is through the combined use of Section 121 and Section 1031. Until recently real estate was classified as either an investment or a primary residence. Upon the sale of property, different tax breaks were available depending on how the property was classified.
If the property was considered an investment, Section 1031 of the Internal Revenue Code could be used to defer the payment of capital gains taxes.
If the property was considered a primary residence, Section 121 of the Internal Revenue Code could be used to avoid the payment of capital gains taxes. Section 121, also known as the homeowner’s exemption, allows taxpayers who have owned and lived in a primary residence for 2 of the past 5 years to avoid taxes on capital gains. If the taxpayer is single, the first $250,000 of gain is exempt, if married, the first $500,000 of gain is exempt.
Recently however the IRS has stated that some real estate transactions can benefit from both Section 1031 and Section 121. Here’s how it works:
A married couple lives in a home for 5 years and has a gain of $600,000. If the married couple were to sell the home as their primary residence, the couple could qualify for Section 121 of the Internal Revenue Code and avoid paying taxes on the first $500,000 of gain. In this case, however, that leaves our married couple with a tax bill on the excess $100,000 gain (approximate $25,000 in taxes). With the new IRS ruling, instead of selling the home as a primary residence, our savvy married couple decides to move out and convert their highly appreciated home into a rental. The couple rents the house out for 2 years, and then sells that house as an “investment”. Now that the house is classified as an investment, our couple is eligible for tax deferral via Section 1031 of the Internal Revenue Code. However, because the property was also a principal residence for 2 of the past 5 years, they are also eligible for their Section 121 homeowner’s exemption.
By converting the house to an investment, the married couple can avoid paying taxes on the first $500,000 of gain, and defer the payment of any gain in excess of $500,000. Keep in mind, most tax advisors believe 1-2 years to be a sufficient time to rent out the property for it to qualify as an “investment”—but be careful not to rent the home out too long—as it must have also been used as a primary residence for 2 of the past 5 years!