1031 - 121 - Depreciation Recapture

[James Craft]

I have a single family residence that I initially purchased as a primary residence, then rented out for some years, and now use as a primary residence again.  During the period as a rental, I depreciated approximately $100K.  I'm looking to sale and use the proceeds toward the purchase a MFP investment.  My capital gain using the original purchase is around $200K, so $300K with the depreciated basis.  I file jointly so I know I'm okay on the cap gain with a 121 exclusion; however, my question is can I use a 1031 exchange to avoid the depreciation recapture?  I know this is doable if it is currently a rental property, but how about my situation where I've converted a previous rental to my primary residence?

[Dave Foster]

@Jesse Fernandez, possibly but theres a couple of pieces of information missing including the amount of depreciation you would be recapturing.  Here's a general framework.

The direction of use is key. The 121 requirements give you those extra three years when you're not using it as primary anymore but you can still claim the exemption. For the 1031 you actually have to be selling an investment property. It can't be a property that was used for investment. It has to be used for investment when you sell it.

So if you're converting a primary to investment you can rent for 3 years and still get to take both 121 and 1031 - because you've lived in it for 2 out of the previous 5 and it was an investment property when you sold. That's why you can do the 1031 portion. 

 But if you're converting an investment property to primary you will only be able to take the primary residence exemption because when you sell it does not qualify for the 1031. It isn't investment property when you sell it.

There's a hierarchy of reducing benefit in a primary residence sale.

1. A property never used as an investment only primary. When you've lived in it for 2 out of the 5 years prior to sale you get the first $250K or $500K of profit tax free - all tax free. No depreciation to recapture because no depreciation.

2. A property you used first as a primary and then converted to investment. If you sell it while you can still claim that you lived in it for 2 out of the 5 years prior to sale then you still get the entire primary residence benefit of #1. But you may have to recapture depreciation for the time it was used for investment.

3. A property that you used for investment and then converted to your primary. Once you have lived in it for 2 out of the 5 years prior to sale you get to take a prorated amount of gain tax free. It is prorated between qualified use ( as primary) that is tax free and non-qualified use (as investment) that is taxed (remember no 1031 option because you are not selling an investment property. You are selling a primary residence that was once an investment property). And you have to recapture depreciation.

4. A property that you used a 1031 to purchase and used as investment and then later moved in. Same rules as #3 but you also have to have owned the property for 5 years minimum before you can take the primary exemption.

Certainly the first two options are the most frequent scenarios.  But we're starting to see #s 3 and 4 much more frequently as the market and the population age.  And the other scenario that is becoming more frequent is the conversion of a primary residence to investment because the gain will exceed the primary residence limits (hellooooo California).  So they do a scenario like #2 and then 1031 the portion of the sale that exceeds the tax free limits.

To all my CPA buddies on BP forgive me and correct me if I've strayed outside the lines at all.  From a 1031 perspective this is something we're dealing with daily.  It's such a powerful use of the code to keep tax dollars in your ...  Bigger  Pockets.