Combining Sections 121 & 1031 for Optimal Tax Treatment

Real Estate Residence Tax Capital Gain Investment

Sections 121 & 1031

As we’ve noted before on HTW, Section 1031 of the IRC applies specifically and exclusively to real property used for business or investment purposes. Section 121, on the other hand, applies to primary residences, and can be utilized to eliminate substantial capital gain upon the sale of one’s property (up to $250,000 for single filers and $500,000 for married filing jointly). Though no taxpayer can use 1031 to exchange his primary residence, the tax code allows taxpayers to simultaneously utilize both of these sections in cases involving mixed use or dual use properties. In the 1031 industry, combining Section 121 and Section 1031 in this manner is commonly referred to as “split treatment.” In this article, we will discuss how this process of combining 121 and 1031 can be achieved.

Combining on the Sale

If a taxpayer has been living in a portion of the property he or she wishes to sell as part of a like-kind 1031 exchange, then the taxpayer may utilize 121 and 1031 on the sale. Suppose that the taxpayer owns a four-unit rental property and lives in one of the units; in this scenario, the taxpayer could sell the property, exclude up to 25 percent of the gain through the exclusion conferred by Section 121 and then defer recognition of up to 75 percent of the remaining gain by acquiring suitable replacement property as part of a 1031 exchange. Hence, in this example, the taxpayer would only be deferring whatever portion of the property is considered used for investment purposes.

Combining after a Conversion

Suppose a taxpayer acquires like-kind replacement property as part of an exchange but then wishes to convert the replacement property into a primary residence. Then, let’s further suppose that the taxpayer wished to sell the property outright after this conversion to a primary residence. In this scenario, the taxpayer would have benefitted initially from Section 1031 on the acquisition, but they would also be able to utilize Section 121 to exclude realized gain on the sale. Current regulations on converted property state that a taxpayer must own a property for a minimum of 5 years after completing a 1031 exchange in order to be eligible to use Section 121; what’s more, taxpayers must also live in the property as their primary residence for at least 2 years during that 5 year period.

Let’s illustrate this: suppose that a taxpayer exchanges into an investment property through a 1031 exchange and then moves into the property 2 years later. Suppose that the taxpayer lives in the property for 3 years and then decide to sell the property. The taxpayer could use Section 121 to potentially exclude up to $250,000 (if filing single), but he would only be able to exclude 3/5 of whatever gain is recognized on the sale. Even though the property would be classifiable as a “primary residence” at the time of sale, Section 121 could only offset a portion of the gain equal to the percentage of time spent living in the property.

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johnAbout john
Seattle CPA+John Huddleston has written extensively on tax related subjects of interest to small business owners. He is a graduate of Washington State University and the University of Washington School of Law.

Huddleston Tax CPAs of Seattle & Bellevue
Certified Public Accountants Focused on Small Business

(800) 376-1785
40 Lake Bellevue Suite 100, Bellevue, WA 98005

Huddleston Tax CPAs & accountants provide tax preparation, tax planning, business coaching, Quickbooks consulting, bookkeeping, payroll and business valuation services for small business. We serve Seattle, Bellevue, Redmond, Tacoma, Everett, Kent, Kirkland, Bothell, Lynnwood, Mill Creek, Shoreline, Kenmore, Lake Forest Park, Mountlake Terrace, Renton, Tukwila, Federal Way, Burien, Seatac, Mercer Island, West Seattle, Auburn, Snohomish and Mukilteo. We have a few meeting locations. Call to meet John Huddleston, J.D., LL.M., CPA, Tawni Berg, CPA, Jennifer Zhou, CPA, Jessica Chisholm, CPA or Chuck McClure, CPA. Member WSCPA.