Taxpayers owning rental property acquired in a 1031 exchange may convert the property from a rental to their primary residence. When the decision is made to sell the primary residence, the 1031 exchange capital gain may be partially eliminated by the Section 121 $250,000 or $500,000 exclusion dependent upon federal filing status. Your CPA familiar with your adjusted gross income and federal tax returns can determine the application of the Section 121 exclusion to the federal and state capital gain.
A 1031 exchange is a tax deferral tax strategy recognized by the Internal Revenue Service Code Section 1031 allowing taxpayers selling real or personal property productively held in a trade, business or investment to defer the federal and state capital gain and depreciation recaptured taxes when like kind real or personal property is acquired for productive use in a trade, business or investment. There are many rules to be followed, so it is suggested to engage your CPA to first determine whether a 1031 exchange makes sense. Once the decision is to initiate a 1031 exchange, engage a Certified Exchange Specialist® to provide the Qualified Intermediary accommodation services.
Internal Revenue Code Section 121 enables taxpayers to exclude up to $250,000 ($500,000 for married filing jointly) of gain when selling their primary residence, given in the five year period ending on the sale date, the property was owned and used by the taxpayer as their principal residence for periods totaling two years or more. The exclusion is available once every two years.
If the taxpayer sells a rental property that was converted and sold as the taxpayer’s primary residence within the five years and satisfies the Section 121 requirements, a 1031 exchange does not need to be initiated given the capital gain excluded by Section 121 eliminates or significantly reduces the taxpayer’s tax. Be aware that depreciation recapture after May 6, 1997 does not qualify for the capital gain exclusion.
Non-qualified use or time held as a rental does not apply to gain from the primary residence sale. Consequently, should the taxpayer use the property as their primary residence for five years and converts to a rental for two years prior to selling, the transaction qualifies for the exclusion. Should the gain exceed the exclusion, the sale qualifies for both the Section 121 exclusion and 1031 exchange deferring the remaining gain into a replacement property.
When selling a primary residence converted from a rental property acquired in a 1031 exchange, a fraction is created to determine the portion of use attributable to non-qualified use not eligible for the Section 121 exclusion. Another fraction represents the portion of the gain that is eligible for the exclusion.
The numerator of the fraction represents the number of non-qualified years after January 1, 2009 the property was held as a rental. The denominator is the total number of years the property was owned including years of non-qualified use prior to January 1, 2009. In the qualified use fraction the number of years the property was held as a primary residence is the numerator and the denominator is the total years of ownership. The qualified use fraction is multiplied by the portion of the capital gain (not including depreciation recapture which is not eligible for the Section 121 exclusion) to be absorbed or eliminated by the Section 121 exclusion.
For example, the taxpayer exchanged into a property in 2010 and held it as a rental for two years prior to converting to a primary residence. The primary was the taxpayer’s principal residence for four years before selling. The aggregate depreciation recapture and time replacement property is held as a rental do not qualify for the Section 121 exclusion. Two thirds (4/6) of the capital gain is eligible for the exclusion. The longer the property is held as a primary, the greater the gain can be applied towards the exclusion.
The American Jobs Creation Act of 2004 requires a 1031 exchange, replacement property to be held for two years or adequate time to qualify as replacement property in a 1031 exchange. In addition, at least two of the minimum five year hold is held as a primary residence to qualify for the Section 121 exclusion. The IRS may challenge replacement property held for shorter than two years prior to conversion.Revenue Procedure 2008-16 establishes a safe harbor defining hold times and fair market rent requirements to qualify the replacement property intent. It is best to maintain an “indeterminate intent” to convert the rental to a primary residence.
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Source Credit – atlas1031.com