Overview of Combining a 1031 Exchange with a 121 Exclusion
The joining of a 1031 Exchange with a 121 Exclusion is an extraordinarily effective combined income tax strategy for any Investor, allowing them to take advantage of tax free exclusion when their property was previously held and used as investment property.
Internal Revenue Code Section 1031 allows a taxpayer to defer the federal and state capital gain and depreciation recapture taxes when selling property held for investment and replacing with “like-kind” property held for investment. Internal Revenue Code Section 121 provides the taxpayer a $250,000 (when filing as an individual) or $500,000 (when filing jointly) exclusion on the capital gain when selling the taxpayer’s primary residence. With careful planning, it is possible to convert a rental property to a primary residence and utilize the Section 121 exclusion when selling to absorb a portion of the capital gain .
1031 exchanges represent a tax deferral strategy that individuals, trusts, married folk and companies use to defer capital gain taxes. Property eligible for consideration includes real estate and both tangible and intangible personal property that is held in the productive use of a business or for investment. Examples include land, rental and commercial properties, thirty year or more leasehold interests, easements, perpetual mineral interests, aircraft, gold and silver bullion, equipment, thoroughbred livestock, vintage cars, franchise and development rights. What is not considered “like-kind” is a primary residence, indebtedness, stocks and securities, inventory and partnership interests.
Many smart investors nearing retirement consider converting a rental property acquired in a 1031 exchange to their primary residence. An understanding of how this works and the benefits is critical. First, the replacement property may be acquired in a 1031 exchange and held for two years as a rental. Hold time is one fact of many that supports the proper intent of a 1031 exchange. A two year hold time, along with renting the property for at least fourteen overnights in each of the two years at fair market rent, is important to also qualify for the IRS safe harbor in Revenue Procedure 2008-16.
Next, the property is converted to your primary residence. The following facts support the converted use including:
- The property is now itemized on Schedule A versus Schedule E of the taxpayer’s federal income tax return as their primary residence
- Registered to vote from this address
- Mail is received at this address
The American Jobs Creation Act of 2004 requires that the property be held for a five-year period beginning on the property acquisition date in the 1031 exchange to combine the 1031 exchange with the Section 121 exclusion.
In a 1031 exchange, the replacement property purchase price less the relinquished property adjusted basis becomes the purchase price used to determine the realized gain. When the property is sold, the sales price less the modified adjusted basis less the selling expenses equals the realized gain. The exclusion applies to 3/5ths and not the 2/5ths of the gain when rented. The exclusion also does not apply to the depreciation recapture.
For example, in a 1031 exchange, land was sold replaced with a vacation rental in Florida, deferring $100,000 in capital gain . After two years of renting the vacation rental, the property was converted and held as a primary residence for three of the total of five years the property was owned. The primary residence is now sold for $300,000 more than the initial purchase price. The total realized gain is $400,000 and $30,000 of that gain was depreciation recapture. The $30,000 is taxable at twenty-five percent recapture, or $7,500, plus with 2/5ths of the $370,000, or $148,000, is subject to capital gain taxes for the two years of nonqualified use as a rental. The federal capital gains tax is dependent upon the taxpayer’s modified adjusted gross income (MAGI) and corresponding tax bracket. If the married couple’s MAGI is less than $250,000 but greater than $72,500, then the federal capital gain tax rate is 15 percent, or $22,200, plus the $7,500 depreciation recapture for an estimated tax of $29,700. A total of $155,500 is not eligible for the Section 121 exclusion but 3/5ths, or $222,000 is tax free.
The conversion of the 1031 rental to a primary that is later sold under Section121 allows for the potential of avoiding taxes on up to $250,000 to $500,000, depending on the variables. Work through the details with your CPA.
Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.
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