Section 1031 of the Internal Revenue Code allows a taxpayer to defer the recognition of gains (or losses) on an investment property when sold if the relinquished property is exchanged for a like-kind replacement property. While Section 1031 does not specify a holding period for the property, the IRS and courts have generally held that two years is adequate. Separately, IRC Section 121 (a) allows for the exclusion of capital gains from the sale of a primary residence of up to $250,000 for a taxpayer, or up to $500,000 for a married couple filing jointly. The IRS has set eligibility for the Section 121 exclusion at two years (ownership and use as main home) during the last five years, with some exceptions.
Revenue Procedure 2005-14 addresses whether Sections 121 and 1031 of the Internal Revenue Code can both apply to one exchange of property. It notes that the American Jobs Creation Act of 2004, Section 840 amended Section 121 (d) of the IRC to clarify that if a taxpayer acquired property via the 1031 exchange process, the Section 121 exclusion of capital gains would not apply if the property is sold or exchanged during the ensuing five-year period.
Also, Section 121 (e) clarifies that if the taxpayer uses one part of a property for a residence and another part for business purposes, and the residential and business portions are together in one dwelling unit, then the entire property is considered residential for the 2-year habitation stipulation. However, the term "dwelling unit" does not include other structures on the property.
Revenue Procedure 2005-14 points out that neither Section 121 nor 1031 addresses the potential for applying both sections to one sale of a property. Still, it notes that Section 121 identifies a similar opportunity with 121 and Section 1033, another nonrecognition provision. In that instance, Congress determined that for property exchanges that met both conditions' requirements, the taxpayer would apply the Section 121 exclusion first, and the gain thus excluded would then be added to the seller's basis as calculated for the replacement property.
Applying that circumstance to the relationship between Section 121 and 1031, the Revenue Procedure 2005-14 guidance concludes that taxpayers may use both the exclusion of gains from the sale of a principal residence and the nonrecognition of profits from the relinquishing of an investment property. Section 121 is applied first, and that exclusion does not apply to any depreciation claimed for the property's business or investment piece. But any gain attributable to the relinquished business portion excluded under Section 121 increases the basis of the replacement business property.
Relevant examples of the application of both sections cited by the IRS guidance include a situation in which the taxpayer initially uses a single home as a residence and subsequently as an investment property. If both are within five years, this allows the taxpayer to meet the requirements of both exclusions. Another example would be a property with two dwelling units, in which the taxpayer uses one as a principal residence and one as a rental property. Alternately, the property might have a home and a retail business.
One crucial 1031 requirement to keep in mind is the use of the Qualified Intermediary to receive, hold, and disburse the funds in the exchange of the relinquished property for the replacement property. This step can involve greater complexity with the inclusion of a residence in the equation. As always, we recommend that you consult your tax advisor before proceeding.