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IRS
Eases Rules
for Combining Home Sale Exclusions and 1031
Exchanges
The
IRS recently issued a ruling further
explaining the handling of real estate transactions
involving both personal residences and investment property.
Under this new ruling, your exclusion from capital gains
tax can be maximized in transactions that involve both
types of properties. Depending on the situation, the
IRS will now allow you to use your entire exclusion
for your personal residence. If you have any gain left
over (above the maximum exclusions), then you can defer
it through a tax-deferred exchange!
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by
Nace Cohen, Florida CPA., Consultant,
The 1031 Exchange Experts |
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IRS code Section 121 lets you exclude $250,000 of gain
if you file a single-return and up to $500,000 excluded
if you file a joint-return when you sell your personal
residence if you have lived there for two of
the last five years.
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| and
by Gary Gorman
Founding Partner,
The 1031 Exchange Experts |
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IRS
code Section 1031 applies to investment property
and allows you to roll the gain from your Old
Investment Property to your New Investment
Property -- thereby defer paying the capital gains taxes.
Remember, this is property you hold for investment or
for business use.
Section 1031 applies to investment property, and Section
121 applies to your residence. What about property that
is, or was both your residence and
used for investment...? Since Section 121 applies if
the property has been your residence for any two of
the last five years -- this raises the question of what
was it the other three years? (Assuming
that you don't live in the property any more...) The
obvious answer is that it was investment property, and
that is where Section 121 and Section 1031 overlap.
For the
last seven or eight years we've been writing articles
and teaching classes about this overlap of the two tax
code sections. Now there's an IRS ruling that verifies
what we've been teaching. What the ruling effectively
says is that when you have real estate that is a possible
Section 121/1031 overlap, you get to maximize the tax
free exclusion of Section 121 first, and then apply
the remainder to Section 1031 exchange.
Here are two examples of how this new rule works. Fred
and Sue are selling a house that they lived in for 24
months (years one and two). During years three and four
they rented the house out (and lived somewhere else).
Now Fred and Sue are selling the house at a gain of
$600,000. How much of this gain is tax free under Section
121 and how much is rollover gain under Section 1031?
Notice that the property was their residence half
of the time, and was rental property the other
half.
Your
inclination would be to treat half
the gain (just $300,000) as tax free under Section 121,
and to roll the other half over via Section 1031. But
under the new ruling you first apply as much of the
gain as you need to maximize the Section 121 gain, with
the balance applied to the Section 1031 gain. So in
this case (Fred and Sue file a joint-return) that means
that the gain to be excluded under Section 121 is $500,000!
And the remaining $100,000 of gain could then be deferred
using Section 1031 by doing an exchange.
Example
Two: Fred and Sue have a one story house with a walk-out
basement. They live up stairs, and the basement is their
office. Their CPA has treated their office as half of
the structure (with their residence being the other
half). Again, they are selling their house at a gain
of $600,000.
As in the
above example, you first apply as much gain as necessary
to maximize your Section 121 exclusion ($500,000), with
the balance ($100,000) applied to the Section 1031 gain.
So, whether the property is currently both your residence
and your office, or if the property was fully your residence
for two years and then used for investment for the other
time, you need to first fully allocate the appropriate
gain as your personal residence, then you can apply
any remaining gain to an exchange. In both of our examples,
the schedule allocating the gain would look like Table 1.
 Two
last things we want to bring to your attention: (1)
You must recapture the depreciation you have taken after
May of 1997; and (2) In our discussion above we assumed
that you would roll over the remaining gain from these
examples using Section 1031. In fact, you may decide
not to do an exchange and therefore
must treat the remaining $100,000 gain as recognized
and pay taxes on it.
This new
ruling is a great gift from the government to every
taxpayer who has property that is part personal residence
and part investment -- whether it's because you have
an office in your home, or because you've treated it
as both an investment and as your primary residence
over the last five years.
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