The Power Duo: Using 121 and 1031 Together to Supercharge Tax Savings The Power Duo: Using 121 and 1031 Together to Supercharge Tax Savings
What is IRC section 121?
Internal Revenue Code section 121 was created on the premise of excluding gain at the time of a primary residence sale. Single filers receive $250,000 exemption on gain while married filers receive a $500,000 exclusion on gain.
Can I Utilize IRC Section 1031 to Defer Capital Gains Tax on the Sale of an Investment Property, and Potentially Move into the Replacement Property at a Later Time and Claim that as a Primary Residence?
The short answer is yes! Exchangers can perform a 1031 Exchange to defer capital gains taxes on the sale of an investment property and eventually move into the replacement property. However, they must wait two full calendar years before claiming a former investment property as a primary residence.
Combining IRC §121 (exclusion of gain from sale of a principal residence) with IRC §1031 (like-kind exchange for investment/business property) is a sophisticated tax planning strategy. Here’s a breakdown of how it can work, including opportunities, limitations, and IRS guidance:
Overview of IRC §121 and §1031
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§121: Excludes up to $250,000 (or $500,000 if married filing jointly) of gain from the sale of a principal residence.
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§1031: Allows deferral (not exclusion) of capital gains tax if investment or business property is exchanged for like-kind property.
Combining §121 and §1031 — The Scenario
This strategy often involves converting a primary residence to rental / investment use, then later exchanging it. This regulation states that the taxpayer must own this property for a minimum of 5 full calendar years prior to using a combination of the two. 121 being classified as qualified use = qualifying for the 121 exemption and 1031 as non-qualifying use = exchange option only.
Investment Property into Primary Residence
A married couple lives in their primary residence for 3 years and qualifies for §121. They convert their property into a rental (i.e., stopped using it as your primary residence) on year 4 and 5 of ownership.
After a minimum of 5 years of owning the property, the couple decides to sell the property and has a gain of $750,000. Since this was first a primary residence and then later converted into a rental, this couple has access to the full exemption of qualifying use (§121 primary use) up to $500,000.
The remaining $250,000 gain can be exchanged into investment replacement property. Use §121 to exclude part of the gain and §1031 to defer the rest. This is the most desirable combination of the two tax codes.
IRS Guidelines (Rev. Proc. 2005-14)
The IRS officially permits both exclusions and deferrals in the same transaction, but they must be applied in this order:
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Apply §121 exclusion first to the extent eligible.
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Then apply §1031 deferment to any remaining gain.
This is a very taxpayer-friendly approach and is directly supported by Revenue Procedure 2005-14.
Primary Residence into Investment Property
A single man buys an investment property for $1,000,000 in 2010 and rents it for 3 years. He then moves into the property in year 4, 5 and 6 (3 years) and claims this property as his primary residence. After 6 years of ownership, the man decides to sell his property for $1,500,000. Since this was FIRST an investment property, the taxpayer receives a fraction of qualified exclusion. Remember, qualified use is the amount of primary residence exemption he can use. To calculate this, we use the amount of years he rented the property divided by the total amount of ownership. 3/6 = 50%. Therefore 50% of the $250,000 Exclusion gain is qualified use for single fliers at $125,000.
The man receives $1,125,000 at time of sale (basis plus qualifying use of gain) and decides to exchange the nonqualified use of $375,000.
How to Get Started Using 121 and 1031 Together to Supercharge Tax Savings
Maximize your equity, minimize your capital gains taxes. By Combining Sections 121 and 1031, you can unlock strategies to keep more of your gains working for you. Plan your tax strategy today. Contact us to schedule a consultation or attend an upcoming workshop!
