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Dream Retirement: How to Marry the Benefits of §1031 and §121

mountain porch 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?

mountain house

Let’s look at some examples.  Consider Jenny and Dave who are two years away from retirement and have owned a piece of appreciated investment real estate for 10 years. They decide to sell it, do a 1031 exchange and use the sale proceeds to buy a replacement property free and clear in a beautiful mountain resort community where they dream of retiring.  As part of a coordinated plan, they rent the new property for two years—coinciding with their last two years of work.  Upon retirement, they sell their current home and realize a gain on the sale of $400,000- which is excluded under Section 121.  At the same time, they discontinue renting their ski chalet  (known as “changing use”), and move into it as their new primary residence.

In this instance, have Jenny and Dave structured their plan to gain the most tax deferral allowed and meet their goals? The answer is a qualified yes.  They have realized their dream to move into their ideal retirement home with no debt, and if they live in the property in two of the next three years, they will be able to hit the “refresh button” and again access the full $500,000 gain exclusion when they sell subject to the restrictions below.

In 2008, the Housing and Economic Recovery Act further modified part of this benefit by making a portion of the investment gain taxable at sale. The capital gain resulting from the sale of the property is allocated based upon the amount of time the property was held as a personal residence (qualified use) vs. investment property (non-qualified use).  But the law included a liberal transition period, and only applies to situations where a non-qualified (i.e. rental use) took place after 12/31/2008.

golf course house

Now, let’s consider the example of Pam and John who sold a tract of investment land and using a 1031, bought a beautiful lake front house near a golf course in 2010.  They rented the property until 2014, when they retired and moved in.  Because the rental activity is taking place after 2008, they will be subject to the prorata formula discussed above when they eventually sell the property.  If they sell it in 2018, they would have effectively split their ownership equally between 4 years of rental use (section 1031) and 4 years as a primary residence (section 121).  If they have a $500,000 gain on the sale of the property, they would then divide the total years of rental use by the total years of ownership to determine the percentage of the gain that will be taxable. In this instance, four of the eight years, or 50%, would be subject to tax.

Conversely, the same formula applies to arrive at the amount of gain that would be eligible for the primary residence exclusion.  In the previous example, 50% or $250,000, would be taxable and the other 50%, or $250,000, would be tax-free under the Section 121 gain exclusion. The longer the couple own and use the property as their personal residence, the higher the percentage of gain that will be eligible for the Section 121 gain exclusion becomes. (For example, if they don’t sell the property until 2022, then 66% or $333,333 of the gain would be eligible for the 121 exclusion.)

Though some of the tax advantages have been watered down for future transactions, there will be still many objectives that can be accomplished by using this strategy.  It is important to get input from your tax professional before changing the use of a property and when planning how to maximize the benefits of IRC §121 and §1031.