back to articles/index As appeared in... March 21, 2007

Using Section 1031
when selling a personal residence

Section 1031 allows you to roll the gain from the sale of your Old Investment Property over to your New. A different code section (Section 121) allows you to permanently exclude $250,000 (if you’re single; $500,000 if you’re married) of the gain from the sale of your personal residence. If the two code sections overlap (because, for example, you use to live in the house and now you rent it, or because you use a portion of your home for your business), the IRS allows you to choose which of the two code sections will give you the best answer. But you don’t have to make an either/or choice; you can actually use both code sections to minimize your taxes.

by Author Gary Gorman Founding Partner, 1031 Exchange Experts, LLC

Let’s start with a basic example: Fred & Sue have lived in their home for five years until they were forced to move as a result of a job relocation. Unable to sell their home, they’ve rented it for the last two years, and now the tenant wants to buy it.

...since they meet the requirements of both code sections, which option should Fred and Sue take...?

Can they sell it and take their $500,000 exclusion because they sold their personal residence? Yes – Section 121 requires that they live in their house for two of the past five years, which they’ve done. Alternatively, can they do a 1031 exchange when they sell it? Yes – Section 1031 requires that the property be investment property (which rental property is) for the last year and a day before you sell it (which works because they rented it).

So, since they meet the requirements of both code sections, which option should Fred and Sue take? In this type of situation I believe you should always take your Section 121 exclusion (the $500,000 gain exclusion) because I believe you should always take your tax-free gain every chance you get. If Fred and Sue did a 1031 exchange on this property (which they could if they wanted to), they would someday have to deal with taxes on the gain on the property. Again, take the tax-free gain every chance you get.

Let’s take our example one step further: let’s assume that the gain on the sale of their house was $600,000. Now what should Fred and Sue do? This now becomes a situation where Fred and Sue want to use both code sections. The first thing the IRS lets you do is take your Section 121 exclusion, so immediately $500,000 of the gain is tax-free, which leaves $100,000 of gain that they can decide to keep and pay tax on, or they could do a 1031 exchange and roll that amount over to another property. If they did an exchange, they would only have to roll over the $100,000 gain.

If Fred and Sue have used a portion of their home for their business, the two code sections interface slightly differently. Let’s assume that they’ve lived in the house for many years, and that one-third of the house has been used as their office for their real estate business. Upon selling the house, they have an overall gain of $600,000. Now how do the two code sections interface?

Since two-thirds of the house was their principal residence, two-thirds of the gain (or $400,000) is the amount of their Section 121 exclusion and the balance of $200,000 could be rolled over in a 1031 exchange. Alternatively, if their office only comprised ten percent of the house, Fred and Sue could take the entire $500,000 exclusion and roll all of the $100,000 balance of the gain over in a 1031 exchange even though the gain attributable to the office was only $60,000 (10% of the $600,000 gain).

In summary, when you have property that qualifies for both Section 121 and Section 1031, take your Section 121 tax-free exclusion first, and then consider rolling the balance over in a 1031 exchange.