combining section 121 gain and 1031 exchange

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combining section 121 gain and 1031 exchange

Tatyana Shevnina
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
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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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    7y

    @Patricia Boulet  And old but very relevant thread.  You will probably qualify for at least a partial exemption of the primary residence portion. When you combine sec 121 and 1031 the mechanism is that you do a 1031 exchange on the sale of the old property and take boot for the amount of the gain attributed to the primary residence.  Normally that boot would be taxable.  But since you qualify for the exemption your accountant zeros that out when they do your taxes so you pay no tax on the primary residence portion and defer tax on the rest.

    Your reinvestment requirements to defer all tax will end up being your net sale minus the amount of boot taken to offset the primary residence exemption boot.

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  • Patricia Boulet
    Member since 2017 · 3 posts · 2 votes
    7y

    Hi Dave,

    Thanks so much for answering my question. We live in CA and are looking for a new CPA who thoroughly understands the tax law as it applies to real estate. Do you take out-of-state clients? We just sold our home in Hawaii and are putting our  2nd home on the market soon. We would like to make sure we handle the combined 121 exclusion and 1031 deferral so that we do not owe taxes. Please let me  know if you are interested in us as clients.

    Thanks,

    Patricia Boulet

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    7y

    @Patricia Boulet, Thank you for the compliment.  However I don't do taxes (not even my own although my own awesome "Turbo Andy Palan" keeps threatening to  fire me and retire).  I only function as a QI for 1031 exchanges.  We don't do tax legal work.  The 1031 is where we live.  You are indeed going to want a good accountant who can guide you through both sec 121 and 1031 along with a QI and your regular real estate professionals.  You're on to a great strategy.  Just want to make sure the execution is perfect.

    I just sent you a pm

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  • Katie L.
    Attorney and CPA · San Diego, CA · Member since 2017 · 590 posts · 422 votes
    7y

    @Patricia Boulet

    Where in CA do you live? I know several great real estate CPAs in Southern California.

    *this post does not create an attorney-client or cpa-client relationship. Readers are advised to seek professional advice.

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