A number of investors own both a primary residence and an investment property or two. They often have an interest in selling one and transitioning into the other, while limiting the tax liability through smart tax planning. While the IRS has issued direct guidance on this subject, there is still confusion among many investors about whether this is possible, and if so, the rules that apply. A brief description of the exclusions allowed under Section 121 (relating to personal residences) and Section 1031 (investment property) may provide some clarity.
In 1997, there were major changes to Section 121, the regulation that deals with gains on personal residences. Previously, if you were 55 or older, you could use your once-in-a-lifetime gain exclusion of $125,000 on the sale of your home. But in 1997, the amount of gain that could be excluded was increased to $500,000 for couples filing jointly, and $250,000 for individuals, as long as they had owned their home for at least 24 months. Additionally, similar to Section 1031, there were no limits on the number of times you could use the exclusion, with the caveat that under Section 121, the home had to have been owned for 2 years or more.
In 2004, the IRS further modified Section 121 to include several requirements if you change the use of investment property that is part of a 1031 exchange. The first is that you must have lived in the property for two years of a minimum five year ownership period and secondly, any depreciation taken after 1997 has to be recaptured.
So, based on these changes, is there a way to maximize both the Section 121 gain exclusion and the inherent benefits of a 1031 exchange?
