combining section 121 gain and 1031 exchange

Specialist · Los Gatos, CA · Member since 2014 · 73 posts · 28 votes

When combining section 121 gain and 1031 exchange, can you take out the section 121 gain or does it have to be included in the cost of the replacement property?

For example, relinquished property is sold for $800K with $600K capital gain, where $500K qualifies for 121 exclusion and $100K is deferred via 1031 exchange. Can you take out $500K tax free and buy a replacement property for $300K? Or do you still need to reinvest the full $800K into the replacement property? I omitted closing costs, etc. for simplicity.

In prior threads, @Dave Foster (can't tag for some reason) mentioned that section 121 gain is boot, but ultimately becomes tax free once 121 exclusion is applied. From that I gathered that $500K can be taken out tax free. Wanted to double check that my understanding is correct.

Thanks in advance!

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Dave FosterBusiness Member

Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes

@Kenneth Reimer and @Tatyana Shevnina, Thanks for connecting with me Tatyana. Now I'm here :)

That is correct - sec 121 is available only for your primary residence that you have lived in for 2 out the previous 5 years. Sec 1031 is only available for investment property. HOWEVER - What happens with the property that you are now using for a rental (1031 qualifying investment property) that you have also lived in for 2 out of the last 5 years (qualifying sec 121 property)? A property in this situation meets both sets of qualifications. If the gain is less than the $500K ($250K if single) then you would just want to apply sec 121 and take the gain tax free. But that still leaves depreciation recapture which could be significant. Even more so if the gain exceeds the limits of sec 121.

The answer is to actually combine the two statutes. You begin a 1031 exchange but take $500K in cash boot. Normally this boot would be taxable in a 1031 exchange. But since you have lived in it for 2 out of the previous 5 years you get that tax free under sec 121.

It's an incredibly elegant solution. And many folks living in houses that would exceed the sec 121 limits decide to retain ownership of their home for a period of time and put it into service so they can then sell and take advantage of sec 121 for tax free cash and defer the rest through 1031.

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Kenneth Reimer
Rental Property Investor · Sacramento, CA · Member since 2016 · 267 posts · 214 votes
9y
@Tatyana Shevnina Tatyana, I don't believe you can combine the section 121 and 1031. Section 121 is for your principal residence, whereas a 1031 exchange is for investment property. If you're married, you'll be able to exclude 500K like you said. If it was an investment property, you would have to move at least $800K to one of the three properties you identified within the first 45 days of closing on your downleg, in order to defer all capital gains. What you don't move, you will pay capital gains on.
Let me know if you have any questions! By the way, you can't tag people who you aren't connected with, nor can you tag people that aren't already on the thread !
Hope this helps!
Kenny Reimer
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Tatyana Shevnina
OP
Specialist · Los Gatos, CA · Member since 2014 · 73 posts · 28 votes
9y
@Kenneth Reimer Thanks for clarifying the tagging, Kenneth!
I thought you can't combine 121 and 1031 too, but apparently you can. Let's say I own the house 2 years as a principal residence, then I rent it out for two years and sell it. I can qualify for 121 and 1031 at the same time. Just need to have a loooot of capital gain to make it worth the 1031 logistics.
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
9y
@Kenneth Reimer and @Tatyana Shevnina, Thanks for connecting with me Tatyana. Now I'm here :)
That is correct - sec 121 is available only for your primary residence that you have lived in for 2 out the previous 5 years. Sec 1031 is only available for investment property. HOWEVER - What happens with the property that you are now using for a rental (1031 qualifying investment property) that you have also lived in for 2 out of the last 5 years (qualifying sec 121 property)? A property in this situation meets both sets of qualifications. If the gain is less than the $500K ($250K if single) then you would just want to apply sec 121 and take the gain tax free. But that still leaves depreciation recapture which could be significant. Even more so if the gain exceeds the limits of sec 121.
The answer is to actually combine the two statutes. You begin a 1031 exchange but take $500K in cash boot. Normally this boot would be taxable in a 1031 exchange. But since you have lived in it for 2 out of the previous 5 years you get that tax free under sec 121.
It's an incredibly elegant solution. And many folks living in houses that would exceed the sec 121 limits decide to retain ownership of their home for a period of time and put it into service so they can then sell and take advantage of sec 121 for tax free cash and defer the rest through 1031.
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Kenneth Reimer
Rental Property Investor · Sacramento, CA · Member since 2016 · 267 posts · 214 votes
9y
@Dave Foster Dave, thank you for the response. So, if I understand you correctly, it would be in someone's interest if they had a SFR, have over $500K in appreciation, have lived in it for an aggregate of 2 out of the last 5 years, have since converted it to an investment property, and also have enough cash to put down on a larger property?
This can't be that common?
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
9y
@Kenneth Reimer, well common is relative of course. When I lived in Fairfield County CT almost every house on the block could have benefited. Much the same could be said of the Bay area (your Bay not mine :). You are right though that what is not common is converting the house into rental for a period to take advantage of both sections because even high demographic folks with good attorneys and planning professionals don't always know this strategy. And it takes planning.
And while it's counterintuitive to think about folks being willing to do this, it's actually an elegant strategy because folks in that income bracket often have other properties - 2nd homes, vacation, international, etc that they feel perfectly comfortable living in while their primary is seasoning as a rental. And they have no need to immediately use funds from the sale to purchase their next primary. So time and money are on their side.
1% is still a large number of people!
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Kenneth Reimer
Rental Property Investor · Sacramento, CA · Member since 2016 · 267 posts · 214 votes
9y
@Dave Foster That's fascinating! What a great solution to have in your pocket for the right investor. Dave, I thank you for taking the time to educate me!
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Jonathan Thompson
Real Estate Investor · Virginia Beach, VA · Member since 2017 · 15 posts · 5 votes
9y
I'm in this same boat right now. I'm gleaning from the above comments that my next statement makes sense. I should only 1031 exchange the amount for the depreciation recapture and 121 the appreciation cap gain. I won't have more than $250/500K cap gains and the majority of the taxes will be depreciation recapture ( 9 years into 27.5 of depreciation of 360K).
John
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
9y
@Jonathan Thompson, you may not be as bad off as you think . The look back is 5 years and you will have lived in it for 2 out of the previous 5 so at the most you will only have 3 years of depreciation to recapture. Still something to think about but not as bad as 9 years to recapture.
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Jonathan Thompson
Real Estate Investor · Virginia Beach, VA · Member since 2017 · 15 posts · 5 votes
9y
Thanks Dave. If I move back into the house, which is likely, and stay for 5 years, does that eliminate the depreciation recapture completely? That seems too good to be true.
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Tatyana Shevnina
OP
Specialist · Los Gatos, CA · Member since 2014 · 73 posts · 28 votes
9y
@Dave Foster -- Thank you very much for your thorough response, Dave!
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
9y
@Jonathan Thompson, Yes that probably would be too good to be true. Even in a sec 121 exclusion i believe most accountants will tell you whatever depreciation was taken during in service times would need to be recaptured unless combining with a 1031 exchange.
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Jim KennedyPro Member
Accountant · Cherry Hill, NJ · Member since 2016 · 173 posts · 201 votes
9y
Something is not right in this. I cant put my finger on it. I emailed an IRS Liaison I know to get his take on it. Ill report back.
Jim Kennedy, CPA
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Michael T. Breen
Plaistow, NH · Member since 2016 · 9 posts · 7 votes
9y
IRC 9722 states that if the principal purpose of any transaction is to evade or avoid liability under this chapter, this chapter shall be applied (and such liability shall be imposed) without regard to such transactions. In English, this means if the transactions doesn't have a business purpose and true economic substance, the transaction or entity creating the tax savings will be disregarded for tax purposes and the correct tax will be imposed. If you google US Tax Court Sham you will see many tax court cases that cite sham with no economic substance and disregard the transaction or entity. There is also a variety of civil penalties that can be assessed based on the facts and circumstances of a particular tax scheme.
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Michael T. Breen
Plaistow, NH · Member since 2016 · 9 posts · 7 votes
9y
Sorry everyone, I was intending to post in ripping off the IRS post
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Eric Lo
Whittier, CA · Member since 2017 · 4 posts · 0 votes
9y
Hi all, lots of expertise on this thread, so can't help myself, I need to get these in: there are a few questions I cannot figure out a practical answer regarding sec 121 and the rule of "2 of the last 5" regarding marriage (to achieve the full $500k exemption). IRS states you must and your spouse must have co-habitated in order to receive the exemption, although it clarifies that you didn't need to be married at the time of co-habitation if you married after. My questions with regards to the practical enforcement by the IRS of this rule:
1) Does co-habitation have to occur during both years of the "2 of 5"? And what happens if its partial co-habitation for one of the two years?
2) What determines co-habitation? For example does it have to be a demonstrated primary residence or would say staying on all weekends meet the bar?
3) Lastly (and perhaps most simple/stupid), when does the 5 year rule start/end and is it based off of 5x365 days of the last day that the home was primary, or is it just in full calendar/tax years (ex. if last day was January 1st of 2010, the exemption would apply as long as the sale occurred before Dec 31 2014)
Thanks!
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Sam DogenPro Member
San Francisco, CA · Member since 2017 · 40 posts · 17 votes
9y
I love this discussion. I'm going through it right now with my problem and San Francisco. I didn't realize you could combine the two. What if you only made $1000 a year in rental income. Does that still qualify? Or do you have to rent it out at market rate? what is everything depending on whether you get audited or not? Thanks
Here's my thread https://www.biggerpockets.com/forums/311/topics/453829-sell-or-keep-renting-out-home-in-san-francisco-2017?page=1#p2817817
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Clayton MobleyPro Member
Birmingham, AL · Member since 2014 · 875 posts · 947 votes
9y
@Sam Dogen I don't believe there is a requirement for how much income the rental produces in order for it to be considered an investment property. But @Dave Foster please chime in here (learning opportunity for me!). I think in the eyes of the IRS, you getting less than you should in rental income just makes you bad at investing, which they don't care about lol. From your other thread I'm guessing you're wondering if you rented it to your son at a reduced rate if that would still count as rental history? I'm not sure if there's any 'intent' stipulations regarding that strategy, as long as you intended to hold the property long-term... hopefully Dave will have some input here.
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
9y
@Clayton Mobley, thanks for the shout out. @Sam Dogen Income itself is not a qualifier of a property for 1031 treatment. However, If the field agent auditing your return were to determine that your intent was not to hold the property for productive use in business trade or investment then they could indeed deem the property not eligible for 1031 but could also remove the "investment" status for normal business deductions. They could rule that the home was personal and not investment. How likely is that? Well it's hard to argue with reported income. The more you treat it like investment the more likely you are to cross any bar that a field agent may raise against you.
In many cases, we'll see discounted rents being handled by the owner charging market rent with a full arms length lease but then gifting back money to the renter under the federal gift limits. Unfortunately in your case the federal limits fall far short of what market rent would be in the Bay.
@Eric Lo, some of your answers are very straightforward. Some are not. In order to take advantage of sec 121 you (and your spouse if you want the $500K limit) must have lived in the property for 2 out of the previous 5 years (or 24 out of the 60 months) prior to the sale.. The 5 year look back is the immediate 5 years prior to the sale of the property. And yes you have to have lived in the property for 2 of those years. The IRS gives you an out if you cohabited but later got married. But they do not give grace on the time period for living there.
As far as determining cohabitation certainly the service doesn't expect you to be there every minute of every day. Folks take extended trips for business and pleasure. There may be long periods at the parents or the vacation property. It's really a question of where do you say you live and there are many things used to demonstrate that. Drivers license, voting records, amazon mailing address, bank statements, conversations with neighbors, presence at the neighborhood cookouts etc.
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Bill ExeterBusiness Member
1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
9y
Hi @Tatyana Shevnina,
Generally, when combining Section 121 ("121 Exclusion") and Section 1031 ("1031 Exchange") of the Internal Revenue Code, you can deduct the tax-free portion from the amount that you must reinvest through the 1031 Exchange transaction. There are always possible exceptions, so be sure to review all of this with your tax advisor.
Hi @Kenneth Reimer,
You can combine a 121 Exclusion and a 1031 Exchange under certain circumstances. The most common structure is when the property was as a primary residence, and subsequently converted into rental property, and then sold within the three year window after the date the taxpayer moved out of the property and converted it into rental use.
The key is that the taxpayer must be able to look back 60 months prior to the closing of the sale and state that they had lived in the property for at least a total of 24 months out of the last 60 months in order to qualify for the 121 Exclusion. And, since the property has been held as rental property since the taxpayer moved out, it qualifies for 1031 Exchange treatment. The key is to rent the property long enough to demonstrate that the taxpayer did in fact have the intent to hold the property for rental, investment or business use.
This combined 121 Exclusion and 1031 Exchange is not necessarily a "common" strategy, but it is not a rare occurrence either. We actually discussed this in all of our 1031 Exchange seminars.
Hi @Jonathan Thompson,
Correct, you would be able to exclude all of your capital gain on a tax-free basis, and then defer your depreciation recapture through your 1031 Exchange. There are a lot of moving parts here, so always make sure that you have your tax advisor review the transaction before proceeding.
Hi @Jim Kennedy,
Please refer to Revenue Procedure 2005-14. This will provide you the guidance from the IRS that you are looking for.
Hi @Michael T. Breen,
Please refer to Revenue Procedure 2005-14. This is actually an IRS approved structure. It is not tax evasion or tax avoidance. I think you indicated your post was in the wrong thread, but just wanted to clarify this for other readers.
Hi @Sam Dogen,
The requirement would be to demonstrate under audit that you did in fact have the intent to hold the property for rental, investment or business use. Charging a significantly below market rent could make it very difficult to prove that you did in fact have the intent to rent the property out. The key is all about proving that you did in fact intend to hold the property for rental, investment or business use, so if you can prove that by other means, the below fair market value rent will not be a deal breaker.
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Jason Tsai
Investor · San Francisco, CA · Member since 2014 · 2 posts · 0 votes
9y
@Dave Foster: "The IRS gives you an out if you cohabited but later got married." I'm in this exact situation. Where is this written in the tax code or the IRS website? I'm trying to look for it but can't find it..
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
9y
@Jason Tsai, Pub 523 gives the only exceptions I know of. In order for both to qualify they must file a joint return. If one spouse meets the ownership requirement then both spouses are considered to meet the ownership test. But both have to meet the residency test.
There may be some extension of a filing reg related to community property states and filing statuses that has been brought to bear on 121 but I've not seen it.
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Jason Tsai
Investor · San Francisco, CA · Member since 2014 · 2 posts · 0 votes
9y
@Dave Foster @Eric Lo, according to Pub 523:
"If you are married and filing jointly, the exclusion limit is usually $500,000. To qualify for this full amount, you must each independently meet all parts of the , earlier, except for the ownership requirement. See , earlier. (Only one of you needs to meet the ownership test.)"
Ownership Test: "If you owned the home for at least 24 months (2 years) during the last 5 years leading up to the date of sale (date of the closing), you meet the ownership requirement."
Eligibility Test: "If your home was your residence for at least 24 of the months you owned the home during the 5 years leading up to the date of sale, you meet the residence requirement. The 24 months of residence can fall anywhere within the 5-year period. It doesn't have to be a single block of time. All you need is a total of 24 months (730 days) of residence during the 5-year period."
I meet the ownership test, but still unsure whether my spouse meets the eligibility test. In particular:
1) "If you are married and filing jointly" -- does this apply to filing jointly for at least the previous/current year or does it have to be married and filing jointly for the whole 5 years?
2) To determine eligibility for the spouse, what if we were not yet married but only cohabited in the 1st of the 5-year period. Do we have to be married to meet this requirement? We got married after cohabiting for 1 year and lived there for one more year for a total of 2 years. To take this to the extreme, what if we were unmarried for the 2 years while we were living in subject property, but later got married after moving out. Here is the scenario:
Y1 - unmarried, started cohabiting
Y2 - unmarried, continued cohabiting
Y3 - unmarried, but moved out and rented out subject property
Y4 - MARRIED and filed jointly
Y5 - married and filing jointly and sells the subject property
In this scenario, would we still qualify for the $500,000 exemption even though we were unmarried for the 2 years and later got married?
Thanks in advance!
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Sam J.
Jersey City, NJ · Member since 2017 · 2 posts · 0 votes
9y
I have a SIMILAR question:
I have a 3-family house in NJ where I live in one unit as primary residence (for last 3 or 3 years of ownership). Now there is an unrealized capital gain of a $1M, that I want to save from taxes. I will use the proceeds to buy another investment property in NJ itself.
1. Can I do both tax exclusion: 121 (to get $500k tax boot for married) AND 1031 exchange (to carry depreciation) if I sell RIGHT NOW?
2. Do I need to move out for a year, and use it as pure investment property then sell it after a year, to claim 1031?
Thanks
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
9y
@Sam J., You're in great shape. If all three of the units are equivalent then 2/3rds of that capital gain would be from investment and 1/3rd from primary residence.
The mechanism is that when you sell you will start a 1031 exchange and take boot in the amount equal to the gain attributed to the primary residence portion up to the maximum allowance of $250K ($500K if married). The remainder will go forward into the 1031.
When you're accountant files your taxes for the following they will offset the boot with the primary residence exclusion. And voila - you have just sold a property with a $1 million gain and received 1/3rd of that gain tax free and tax deferred the other 2/3rds.
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Patricia Boulet
Member since 2017 · 3 posts · 2 votes
7y
Hi Dave Foster,
Thanks so much for your answer above. We too, are combining a 121 and 1031 to increase our tax savings. Overall, we have lived in the house for about half the time and half of the time we rented it out. My question is, would we have to reinvest in a property of equal or greater value than the sales price of our home or would it be a percentage, in this case 50%, of the sales price?
Thanks in advance,
Patricia
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