How Does a 1034 Exchange Work?

Posted Mar 12, 2023


Once upon a time, before the late 1990s, you could sell your personal residence for a profit. The issue, however, was that the capital gains on that sale might automatically trigger a taxable event in the form of capital gains taxes. Unlike today, those tax rates were high, averaging 28%

There was one way out, though. If you used the proceeds of your house sale to buy a replacement home of greater value, you could defer the recognition of that capital gain. 

This “exchange” was allowed under 26 U.S. Code § 1034 – “Rollover Of Gain On Sale Of Principal Residence.” With the help of Section 1034, you didn’t have to assume a burdensome tax if you earned a profit on the sale of your house. But while this was helpful, it didn’t provide full tax relief for home sales. That wouldn’t come until the late 1990s. 

The Origins of Section 1034 

Congress enacted Section 1034 in 1964 to provide rules that supported gain non-recognition concerning home sales. Specifically, if a taxpayer sold a residence after December 31, 1953 and bought/built another within a specific time period (two years), the gain from the original sale wouldn’t be recognized. At least not if the new residence was sold for “an amount at least as large as the adjusted sales price of his old residence.”  

However, if the new residence cost less than the adjusted sales price of the sale of the old one, “gain is recognized to the extent of the difference.” In other words, if there was money left over from the purchase of a new home, that extra would be taxed as a capital gain. In other words, you’d pay a capital gains tax of 28% (on average) on that extra. 

Another interesting aspect of Section 1034 is that losses weren’t recognized on the sale. Only gains. 

Section 1034 went a long way toward helping homeowners avoid taxes on capital gains following the sale of their homes. But this initiative was repealed for something a little more beneficial to homeowners. 

Enter the Taxpayer Relief Act 

The Taxpayer Relief Act of 1997 provided more relief to homeowners in connection with capital gains recognition and taxes. For one thing, it reduced the marginal long-term capital gains tax rate from 28% to 20%. It also changed the tax treatment of capital gains from the sale of houses. 

Specifically, TRA97 replaced 26 U.S. Code § 1034 with 26 U.S. Code § 121 - Exclusion of Gain from the Sale of Principal Residence.” Section 121 says that any capital gain recognition on a home sale can be excluded up to $500,000 (for taxpayers who are married, filing jointly) or $250,000 (single filers). This recognition means no capital gains taxes on that amount. 

But Section 121 doesn’t give you license to just buy a house, sell it immediately, and collect the capital gains tax free. Nor can you use this if the homes you buy are for investment purposes only. The IRS requires an “ownership and use test” for Section 121 qualification. This means that: 

  • The 24 months don’t have to be consecutive 

Shifting Capital Gains Treatments 

The IRC continues to evolve in its efforts to handle capital gains recognition and taxes. This was apparent both in the introduction and eventual repeal of Section 1034. However, selling a personal residence can generate many questions concerning taxes. For answers, be sure to check with your qualified tax advisor. 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

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