Question: Jon bought a house for $210,000 and used it as his principal residence from 2010 to 2018. From 2019 until 2021, he rented the house to tenants and claimed depreciation deductions of $20,000. In 2021, he plans to exchange the house for $10,000 of cash and a townhouse with a fair market value of $460,000 that he will rent to tenants. Since Jon used the house as a principal residence for two out of the last five years, can he qualify for both §§121 and 1031?
Answer: Yes. Jon’s example is from Rev. Proc. 2005-14, Example 1, and continues below.
Jon’s exchange of a principal residence that he rents for less than three years, for a townhouse intended for rental and cash, satisfies the requirements of both §§121 and 1031. Section 121 does not require the property to be the taxpayer’s principal residence on the sale or exchange date. Because Jon owns and uses the house as his principal residence for at least two years during the five-year period prior to the exchange, he may exclude gain under §121. Because the house is investment property at the time of the exchange, he may defer gain under §1031.
Under Section 4.02(1) of Rev. Proc. 2005-14, as Jon’s preparer you will apply §121 to exclude $250,000 of the $280,000 gain before applying the nonrecognition rules of §1031. The remaining gain of $30,000 is deferred, including the $20,000 gain attributable to depreciation, under §1031. Although Jon receives $10,000 of cash (boot) in the exchange, he 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.
These results are illustrated as follows:
- Amount realized - $470,000
- Less adjusted basis - (190,000)
- Realized gain - $280,000
- Less gain excluded under §121 - (250,000)
- Gain to be deferred - $30,000
Jon’s basis in the replacement property is $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 he receives ($10,000).
Rev. Proc. 2005-14 has six examples that further demonstrate the interaction of §§121 and 1031. This revenue procedure was issued before nonqualified use was enacted into law. However, Jon escapes nonqualified use because the rental activity took place during the five-year period after he used it as his principal residence [§121(b)(5)(C)(ii)(I)]. Lastly, the instructions to Form 8824, Like-Kind Exchanges, indicate how to fill out Form 8824 using the benefit of the §121 exclusion.
Information included in this article is accurate as of the publish date. This post is not reflective of tax law changes or IRS guidance that may have occurred after the date of publishing. All taxpayer circumstances are different, and NATP recommends contacting research services if you have specific questions about your clients’ tax situations.