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1031 Exchanges
Involving Your Personal Residence
1031 exchanges involve property you
hold for investment, not your personal residence. So
why write an article about doing a 1031 exchange on
your personal residence? Everyone knows that
your personal residence does not qualify for a 1031
exchange! Or does it?
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by
Author Gary Gorman
Founding Partner,
The 1031 Exchange Experts |
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When you sell a residence you’ve
lived in for two of the last five years, $500,000 of
the gain is tax free if you’re married; ($250,000
if you are single). This is your personal residence,
which does not have anything to do with 1031 exchanges,
right? However it might. You know the two-of-the-last-five-years
rule, but did you ever ask yourself what the property
was used for during the other three years?
Let’s say Fred and Sue buy a
house that they live in during years one and two. At
the end of year two, they move out and turn the house
into a rental property and rent it out for years three,
four and five. When they sell it at the end of
year five, does the property qualify for the personal
residence exclusion? Yes, because Fred and Sue
lived there for two of the five years preceding the
sale. Does it also qualify for a 1031 exchange? Yes,
because it was investment property for the last year-and-a-day
before they sold it.
When two IRS code sections overlap,
like the sale of a personal residence and Section 1031
do in this example, the IRS lets you pick the code
section that gives you the biggest benefit. So
which should you pick? In this example, Fred and Sue
should treat the transaction as the sale of a personal
residence because doing so will allow them to take
up to $500,000 of their gain off the table tax free – they’ll
never have to pay tax on this money again. If
they treated the sale as a 1031 exchange, they would
end up paying tax on the gain someday even though the
gain would be deferred right now.
What if the gain from the sale of their
house exceeds their personal residence exclusion? Then
Fred and Sue are allowed to maximize their exclusion
and can roll the rest of the gain over in a 1031 exchange. For
example, assume that they sell the house for a gain
of $600,000. They first apply their personal
residence exclusion of $500,000, which leaves a gain
of $100,000. Then they may rollover the $100,000
in a 1031 exchange to avoid being taxed on any of it.
Now let’s take a different example
showing a different interplay of these two code sections:
Let’s say Fred and Sue are selling a four-plex
that they’ve owned for more than two years. During
the time they owned it, they lived in one unit as their
residence and rented out the other three units. In
situations like this, they have a transaction that
is a combination of both code sections – they
have both the sale of their personal residence (for
one fourth of the sale), and a 1031 exchange (for three
fourths of the sale). In effect, they have two
transactions with this one sale.
So just because you are selling a residential
property, there may still be a 1031 exchange angle
that will help you defer the tax.
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