Real estate investors who want to sell highly appreciated residential investment assets can use 1031 exchanges to defer capital gains taxes. But there’s another important tax-advantaged tool at your disposal that may be combined with a 1031 exchange to provide additional tax benefits.
In this article we’ll look at potential scenarios of combining a 1031 exchange with a Section 121 exclusion, which provides homeowners with a significant tax deduction when they sell their primary residences.
Overview of the 1031 Exchange Process
Real estate investors who sell investment properties can defer any realized capital gains, depreciation recapture, and Affordable Care Act taxes by rolling all sale proceeds over into a like-kind replacement property.
Investors can use the exchange process indefinitely to defer those tax liabilities. When they die, they can bequeath their real property interests to their heirs, who will receive a one-time step-up in basis that could eliminate any accumulated tax liabilities.
There are two important considerations when working through a 1031 exchange:
- There’s a 45-day deadline to identify a replacement asset after the close of sale on your relinquished property, and a 180-day deadline to close on the like-kind asset.
- You have to engage a qualified intermediary to facilitate the exchange process.
Exchangors have no leeway when it comes to those two factors. A missed deadline or failure to use a qualified intermediary to hold all sale proceeds and complete the exchange process will result in a disqualified exchange.
What Is a Section 121 Exclusion?
Section 121 of the Internal Revenue Code, called the principal residence tax exclusion by accountancy professionals, allows homeowners to exclude a certain amount of taxable gains when they sell their principal residences. Single filers can exclude up to $250,000 in realized gains, while married couples filing jointly can exclude up to $500,000.¹
In order to qualify for this exclusion, homeowners must have occupied the residence for at least two years in a five-year period prior to selling the home. The 24-month occupation requirement doesn’t have to be consecutive. This restriction is important, though, because it exempts home flippers and owners of second or vacation homes from claiming a Section 121 exclusion. Lastly, this exclusion can only be claimed once every two years – if you sold a home and bought a house with the proceeds but sold that property after 18 months, you would generate a taxable event on any realized gain from disposition of the second residence.
Combining a 1031 Exchange and Section 121 Exclusion
There are a limited number of scenarios where investors would combine a 1031 exchange with a Section 121 exclusion since the latter is limited to primary residences. We’ve briefly outlined these situations, but it should be noted that each requires strategic planning with an experienced tax professional.
- Investment property that was converted into a primary residence. If you bought an investment property but later decided to live in it, you must stay there for at least two years before claiming a Section 121 exclusion. Once you satisfy this requirement, you can claim the exclusion or relinquish the asset as the first part of a 1031 exchange.
- A 1031 exchange rental that was later occupied as a primary residence. This scenario involves an investment property acquired through a 1031 exchange. In order to ensure that exchange is not disqualified, you would have to keep the property in service as a rental for a minimum of 18 months to ensure you can demonstrate the property was acquired for investment purposes. After that time, you would have to occupy the residence for a minimum of 24 months before claiming the Section 121 exclusion. The final stipulation in this scenario is that you must hold the property for a minimum of five years in order to claim the Section 121 exclusion.
- Converting a primary residence into a rental property. The last scenario involves a property you formerly lived in but converted into a rental. In order to get a full Section 121 exclusion, you would have to have lived in the house for a minimum of two years. You also would have to have the property in service as a rental for a minimum of 12 to 18 months to demonstrate the asset is held for investment purposes, a requirement of 1031 exchange properties. Once you can meet the intent of both those covenants, you should be able to claim the full Section 121 exclusion as well as qualify for a 1031 exchange.
The Bottom Line
Many tax advantages can be gained from a 1031 exchange or a Section 121 exclusion. Combining the two requires many years of advance planning to ensure you meet the requirements of both. Working closely with experienced tax professionals can help investors take advantage of these tax-planning strategies.
Sources:
1. Section 121 – Exclusion or Gain From Sale of Principal Residence, IRS.gov, https://www.irs.gov/pub/irs-drop/rr-14-02.pdf
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. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
