1031 Exchange News You Can Use
April 2005  © 2005 David M. Gorenberg and Benjamin L. Dash



Home Sweet Home: Exchange of Former Principle Residence Under Section 1031

By: David M. Gorenberg, Esq., CES® and Benjamin L. Dash, Esq.

The interaction of §121 (exclusion of gain on the sale of a principle residence) and §1031 (non-recognition of gain or loss in like-kind exchanges) has long been the subject of confusion for taxpayers. Recently, the Internal Revenue Service issued Revenue Procedure 2005-14, roviding clear guidance on this issue.

Section 121(a)provides that a taxpayer may exclude gain realized on the sale or exchange of property, if the property was owned and used as the taxpayer´s principal residence for at least 2 of the preceding 5 years.

Section 121(b) provides generally that the amount of the exclusion is limited to $250,000 ($500,000 for certain joint returns).

Section 121(d), as amended by the American Jobs Creation Act of 2004, Pub. L. 108-357, provides that, for sales or exchanges commenced after October 22, 2004, taxpayers who acquired property in an exchange to which § 1031 applied, must hold the property for five years from the acquisition date before they may apply the § 121 exclusion.

Section 1031(a) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment (relinquished property) if the property is exchanged solely for property of like kind (replacement property) that is to be held either for productive use in a trade or business or for investment.

Under § 1031(b), gain must be recognized, however, to the extent that the taxpayer also receives cash or property that is not like-kind property (boot) in an exchange that otherwise qualifies under § 1031(a).

Revenue Procedure 2005-14, issued February 14, 2005, "applies to taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the exchange of a principal residence under § 121 and the nonrecognition of gain on the exchange of like-kind properties under § 1031." The Revenue Procedure applies only to taxpayers who satisfy the 'held for productive use in a trade or business or for investment' requirement of § 1031(a)(1) with respect to both the relinquished business property and the replacement business property. Since neither §121 nor §1031 addresses the application of both sections to the exchange of a single piece of property, this Revenue Procedure was necessary to provide guidance to taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the exchange of a principal residence under § 121 and the nonrecognition of gain on the exchange of like-kind properties under § 1031.

To garner the benefits of both §121 and §1031, new rules must be followed:

(1) Application of § 121 before § 1031. Section 121 must be applied to gain realized before applying § 1031;

(2) Application of § 1031 to gain attributable to depreciation. Under § 121(d)(6), the § 121 exclusion does not apply to gain attributable to depreciation deductions for periods after May 6, 1997, claimed with respect to the business or investment portion of a residence. However, § 1031 may apply to such gain; and

(3) Treatment of boot. In applying § 1031, cash or other non-like kind property (boot) received in exchange for property used in the taxpayer´s trade or business or held for investment (the relinquished business property), is taken into account only to the extent the boot exceeds the gain excluded under § 121 with respect to the relinquished business property.

The Revenue Procedure continues with an example in which Taxpayer A (an unmarried individual) buys a house for $210,000 that A uses as A´s principal residence from 2000 to 2004. From 2004 until 2006, A rents the house to tenants and claims depreciation deductions of $20,000. In 2006, A exchanges the house for $10,000 of cash and a townhouse with a fair market value of $460,000 that A intends to rent to tenants. At the time of the exchange, A had an adjusted basis in the property of $190,000, and realizes gain of $280,000 on the exchange.

A´s exchange of property that was a principal residence, and that was rented for less than 3 years, for a townhouse intended for rental and cash satisfies the requirements of both §§ 121 and 1031. Section 121 requires that the property be used for at least 2 of the preceding 5 years, and does not require the property to be the taxpayer´s principal residence on the sale or exchange date. Thus, A may exclude a portion of the gain under § 121. Because the house is investment property at the time of the exchange, A may also defer a portion of the gain under § 1031.

Under Revenue Procedure 2005-14, A must first apply § 121 to exclude $250,000 ($280,000 minus $20,000 depreciation, minus $10,000 cash received) of the $280,000 gain before applying the nonrecognition rules of § 1031. A may then defer the remaining gain of $30,000, including the $20,000 gain attributable to depreciation, under § 1031. While A received $10,000 of cash (boot) in the exchange, A is not required to recognize gain because the boot is taken into account for purposes of § 1031(b) only to the extent the boot exceeds the amount of excluded gain.

A´s basis in the replacement property was $430,000, which is equal to the basis of the relinquished property at the time of the exchange ($190,000) increased by the gain excluded under § 121 ($250,000), and reduced by the cash A receives ($10,000).

While this new Revenue Procedure is effective as of January 27, 2005, it may be applied to any taxable year for which the statute of limitations has not yet expired.

While the Internal Revenue Service has clarified many of the issues surrounding the interaction of these two Sections, the interaction of §121 and §1031 is not for the faint of heart. The underlying vagaries of §1031 and the gauntlet of Regulations, Revenue Rulings and cases requires careful planning and attention be employed in all like kind exchanges.

Benjamin L. Dash is a partner in the firm of Dash, Reynolds, Shmukler & Dash in Moorestown. David M. Gorenberg is vice president of LandAmerica Exchange Company, with offices in Philadelphia, and in Mt. Laurel and Parsippany, New Jersey, and is the first Certified Exchange Specialist® in New Jersey.