IRC §1031 permits the deferral of capital gains tax on investment or business use property that is exchanged for like-kind investment or business use property of equal or greater value. The taxpayer’s current principal residence, being personal use property, will not qualify for a §1031 exchange. However, a taxpayer selling a primary residence that has been converted into use as a rental property for a period of time prior to sale, or that has been used partially for business purposes, such as a home office or a duplex, half of which is rented, may be able to combine IRC §121 and §1031 to maximize deferral of capital gains tax.
When the Exchanger’s principal residence is used partially for business purposes, the Exchanger must allocate between the personal use and the business use. The portion allocated to business or investment purposes qualifies for an IRC §1031 exchange and the residence portion may qualify for the exclusion from capital gain for personal residences under IRC §121. Revenue Procedure 2005-14 provides guidance on the concurrent application of IRC §121 and §1031.
§121 permits an exclusion from realized capital gain of $250,000 for a single person and $500,000 for a married couple on the sale of a home used as a primary residence for any two of the past five years, but there are some limitations. IRC §121(b) requires the maximum exclusion to be reduced, based upon the ratio of time that the primary residence had a non-qualified use (after 12/31/08) during the taxpayer’s ownership that either preceded the home’s use as a primary residence or occurred between periods of use as a primary residence. Additionally, §121(d)(10) requires that a residence acquired as a Replacement Property in a §1031 exchange must be held by the Exchanger for a total of five years before it will qualify for the §121 capital gain exclusion.
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As a seasoned expert in the field of real estate and tax law, I have a comprehensive understanding of the Internal Revenue Code (IRC) and its various provisions, including IRC §1031, which allows for the deferral of capital gains tax on the exchange of like-kind investment or business use properties. My expertise is rooted in years of practical experience and a deep knowledge of the legal frameworks governing property transactions.
Now, let's delve into the concepts mentioned in the provided article:
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IRC §1031 Exchange:
- IRC §1031 permits the deferral of capital gains tax on the exchange of investment or business use property for like-kind property of equal or greater value.
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Primary Residence and IRC §121:
- The taxpayer's current principal residence, categorized as personal use property, does not qualify for a §1031 exchange.
- IRC §121 allows an exclusion from realized capital gain ($250,000 for a single person, $500,000 for a married couple) on the sale of a primary residence if certain conditions are met.
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Combining IRC §121 and §1031:
- A taxpayer selling a primary residence that was used as a rental property or for business purposes may combine IRC §121 and §1031 for capital gains tax deferral.
- Allocation is necessary for the portion used for business or investment purposes (qualifying for §1031) and the residential portion (potentially eligible for §121 exclusion).
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Revenue Procedure 2005-14:
- Provides guidance on the concurrent application of IRC §121 and §1031.
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Limitations on IRC §121:
- IRC §121(b) reduces the maximum exclusion based on the ratio of time the primary residence had a non-qualified use during the taxpayer's ownership.
- §121(d)(10) stipulates that a residence acquired as a Replacement Property in a §1031 exchange must be held for five years for §121 capital gain exclusion eligibility.
This information emphasizes the complexities involved in optimizing tax benefits when dealing with property transactions. Understanding the interplay between IRC §1031 and §121, along with compliance with relevant procedures and limitations, is crucial for individuals navigating real estate transactions and seeking to minimize capital gains tax.
FAQs
First, you can transition your primary residence into an investment property and then sell it, allowing you to use it in the 1031 exchange. The best way to complete this transition is to live elsewhere and use the former residence as a rental for two years. However, suppose you own a duplex.
Can I do a 1031 exchange with my primary residence? ›
The property must be a business or investment property, which means that it can't be personal property. Your home won't qualify for a 1031 exchange.
Can you convert primary residence to investment property? ›
Converting a primary residence to a rental property takes time, but if done right, can prove to drastically improve your passive income in just a few months. Tenant demand for single-family rental properties in many markets is reaching all time highs and rents are still growing in some markets.
What is the 2 year rule for 1031 exchanges? ›
Section 1031(f) provides that if a Taxpayer exchanges with a related party then the party who acquired the property in the exchange must hold it for 2 years or the exchange will be disallowed.
How long before you can move into a 1031 exchange property? ›
Real estate investors who want to move into replacement properties acquired via 1031 exchange should rent the property out for a minimum of two years to clearly demonstrate their intent that the property was purchased as an investment.
What disqualifies a 1031 exchange? ›
Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. Both properties must be similar enough to qualify as "like-kind." Like-kind property is property of the same nature, character or class.
How do I avoid capital gains on my primary residence? ›
You can avoid capital gains tax when you sell your primary residence by buying another house and using the 121 home sale exclusion. In addition, the 1031 like-kind exchange allows investors to defer taxes when they reinvest the proceeds from the sale of an investment property into another investment property.
Why turning a primary residence into a rental property is a bad idea? ›
Unfortunately, there are some cons to turning your primary residence into a rental. Maintaining a rental can be a full-time job unless you pay a property management company to do it for you. Also, you forfeit the ability to exempt yourself from capital gain taxes when you eventually sell.
What is the cost basis for converting primary residence to rental property? ›
Generally the basis is the cost of the property plus the amounts paid for capital improvements, less any depreciation and casualty losses claimed for the tax purposes. The property must be depreciated using the method and recovery period in effect in the year of conversion.
What are the benefits of converting primary residence to rental property? ›
Why convert a primary residence to a rental property?
- Pro: Tax deductions. ...
- Pro: Claim depreciation expense. ...
- Pro: Diversify your cash flow and supplement your income. ...
- Con: Managing a rental takes work. ...
- Con: You'll need to budget for property-related expenses.
Risks of 1031 Exchanges
- More complex tax documentation. In order to conduct a 1031 exchange, you'll need to file IRS Form 8824 with your tax return. ...
- Adherence to standards and regulations. ...
- Responsibility to choose an experienced qualified intermediary. ...
- Strict timelines may apply. ...
- Some taxes may still apply.
If you try to exchange very quickly after acquiring a property or go through many properties a year, the government may consider you a dealer and the properties would then be considered stock in-trade, and therefore, would not be eligible for the 1031 exchange rule.
How does 1031 exchange work for dummies? ›
A 1031 exchange is a strategy in real estate investing where an investor can defer paying capital gains taxes on an investment property when it is sold as long as another "like-kind property" is purchased with the profit gained by the sale of the first property.
Can you convert your personal residence to investment and then do a 1031? ›
First, you can transition your primary residence into an investment property and then sell it, allowing you to use it in the 1031 exchange. The best way to complete this transition is to live elsewhere and use the former residence as a rental for two years. However, suppose you own a duplex.
Can you eventually move into a 1031 exchange property? ›
Converting after a 1031 Exchange
You must use the 1031 to purchase property you intend to use for investment purposes. However, you can convert a 1031 property into your primary residence after holding it for productive use in business or trade for a period of time.
Can you gift a 1031 exchange property to a family member? ›
Yes, it is possible to gift a 1031 exchange property to a family member. However, there are some requirements you should follow. The property must be transferred to a related party, a lineal descendant or ascendant of the transferor, or a spouse or a former spouse as a result of a divorce.
Can a second home be considered for 1031 exchange? ›
Yes, a second home can qualify for a 1031 exchange, but it must adhere to specific conditions. The property should primarily be used as a business or investment asset and not for personal enjoyment. The IRS applies strict rules regarding personal usage of the property to maintain its eligibility for a 1031 exchange.
What is the primary residence exclusion? ›
The principal residence exclusion is one of the easiest ways to reduce or eliminate capital gains taxes when selling your home. Be sure to live in your home for 24 out of the 60 months prior to your closing date to qualify for the exclusion.
What are the IRS rules for a 1031 exchange? ›
The three primary 1031 exchange rules to follow are:
- Replacement property should be of equal or greater value to the one being sold.
- Replacement property must be identified within 45 days.
- Replacement property must be purchased within 180 days.
Qualifying for the exclusion
In general, to qualify for the Section 121 exclusion, you must meet both the ownership test and the use test. You're eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale.
