Hello BPers,

Question about combing a home sale gain with a 1031 exchange. My wife and I lived in our prior single family home for 9 years until 2017 then rented it out since (+2 years). The house has appreciated about 800k. We are curious if we can do a 1031 exchange but also claim the 500k home-owner deduction.  For example, assuming it is exchanged to a MFH of the exact same price. Can I get 500K cash in my pocket and only keep 300k gain in the replacement property. If so, how does the sale proceed work with QI?  

I read an article about this https://www.bradyware.com/combine-home-sale-gain-exclusion-with-like-kind-exchange/  but it does not answer to my specific question.

Thank you

Originally posted by @Eugene Cheng :

Hello BPers,

Question about combing a home sale gain with a 1031 exchange. My wife and I lived in our prior single family home for 9 years until 2017 then rented it out since (+2 years). The house has appreciated about 800k. We are curious if we can do a 1031 exchange but also claim the 500k home-owner deduction.  For example, assuming it is exchanged to a MFH of the exact same price. Can I get 500K cash in my pocket and only keep 300k gain in the replacement property. If so, how does the sale proceed work with QI?  

I read an article about this https://www.bradyware.com/combine-home-sale-gain-exclusion-with-like-kind-exchange/  but it does not answer to my specific question.

Thank yoU

Yes, on the high level. @Dave Foster , can tell you how is cash dealt with. 

Since you occupied it over 2 years 

You can sell it fully tax free if you do so before it has been a rental for a total of 3 years (you didn't give exact dates). So if it's been a rental for say 2 yeras and 5 months right now- you could sell it tax free. 

YOu would only pay depreciation recapture. 

Is your anticipated gain over $500k?

To clarify: 

You mentioned appreciation of $800k 

But gain will be Calculated as:

Sale price 

<Less> Adjusted basis (purchase price + purchase costs- depreciation)

<Less> Improvements you made 

<Less > Selling costs 

yes 800k appreciation already reflects all the costs (commission, expenses, improvements etc).

it has been rented for a total of 2 year and 6 days. 

@Eugene Cheng , then boy is it your lucky day!  This is an investment property so eligible to do a 1031 exchange.  It was your primary residence for  2 out of the 5 years immediately prior to the sale then you would be eligible to take the first $500K in gain tax free as a married couple.  So this property qualifies for both.

The mechanism we'd use with you is to sell the property and do a 1031 exchange.  But you would take $500K in boot.  Normally this boot would be taxable but since you qualify for the 121 exemption your accountant files the appropriate form with your tax return and that $500K is tax free.

Meanwhile the remainder of the gain ($300K ish) and all depreciation recapture go into the 1031.  

So yes you get to put $500K in your pocket tax free.

From a reinvestment perspective let's just say that your basis was $400K.  It appreciated $800K so you sell it for 1.2 mil.   You would take $500K in boot and would then need to purchase at least $700K of real estate using the remaining proceeds in order to fully defer the rest of the tax.

An awesome strategy!  Congratulations                   

@Dave Foster . Thank you for the detailed reply. Super useful!

In your example assume the original house has a mortgage of 300K, do I still need to get $300K+ mortgage of the $700K+ replacement property? my understand is no (e.g. I can get a mortgage of only 200K) but I am not sure.

@Eugene Cheng , You don't have to technically replace a mortgage with new mortgage.  The actual requirement if you want to defer all tax is simply that you purchase at least as much as your net sale and that you use all of your proceeds from the sale in the purchase.  If you had a mortgage before you can replace that with other funds.  Most people don't have access to that kind of money or they don't want to use it.  So they end up taking a new mortgage.  But they don't have to.

Here's how it would play out in the scenario we were talking about.

You sold for 1.2 with a 300K mortgage.  So you end up needing to purchase at least 1.2 in real estate using $900K of proceeds.

But first you took $500K in boot (remember, normally taxable but going to be applied against your 121 exemption).  So after that your new reinvestment requirements would be to purchase at least $700K in real estate using $400K in proceeds.

You have three options at this point.

1. bring in $300K of outside cash from anywhere to replace the mortgage.

2. Take out a new mortgage for the $300K

3. Purchase less and take out less mortgage.  In this scenario you will pay tax on the difference.

@Dave Foster thank you again for the terrific and clear answer. the 1031+121 combo really offers the best flexibility!