Application of Section 1031 and Section 121

The ability to defer or exclude depreciation recapture and/or capital gain income tax liabilities is a tremendous and significant benefit to a taxpayer – the importance of which cannot be understated.


The deferral or exclusion of any expenditure, especially income taxes, allows the taxpayer to keep one hundred percent of his or her investment dollars earning, growing and building cash flow and net worth over the long-term. The difference between paying taxes now and deferring them over the long run on an investor’s net worth is staggering, and the ability to permanently exclude the payment of taxes is phenomenal.


Section 1031 Exchanges


Taxpayers have been able to structure the sale or disposition of an investment property and the subsequent acquisition of another investment property as a 1031 exchange for many years . The 1031 exchange allows a taxpayer to defer his or her depreciation recapture and capital gain income tax liabilities when selling or disposing of one or more investment properties (“relinquished property”) and acquiring one or more like-kind investment properties (“replacement property”).


The only thing better than the deferral of income taxes is the ability to permanently exclude them all together.


Section 121 Exclusions


Taxpayers have been able to sell or dispose of a primary residence and exclude from taxable income up to $250,000 in capital gains if a single taxpayer or up to $500,000 in capital gains if married and filing a joint income tax return under the 121 Exclusion. The 121 Exclusion is a permanent exclusion from taxable income (i.e. tax free; not tax deferred) and is a fantastic tax planning tool for taxpayers to use.


The requirements for a 121 Exclusion are fairly simple. The taxpayer must have owned the property and lived in the property as his or her primary residence for at least 24 months out of the last 60 months in order to exclude the capital gain from income. The taxpayer can take advantage of the 121 Exclusion once every two years.


In fact, many taxpayers do not – and should – pay close attention to the market value of their primary residence and the corresponding capital gain in their primary residence in order to determine if they should sell and lock in the tax free benefits of a 121 Exclusion. The amount of capital gain in excess of the $250,000 or $500,000 limitation will be generally be taxable, so they should at least consider selling when their capital gain is approaching this exclusion limitation.


What happens when the real property has been held, treated and reported as both a primary residence and a rental or investment property or has been used in a trade or business?


Multi-Use Property

It is not uncommon for a taxpayer to convert property from one use to another such as converting a primary residence into investment property by moving out of the property and begin renting it out or using it in his or her business, or by converting an investment property into a primary residence by moving into the property and treating it as his or her primary residence. Property can also be used as both investment property and as a primary residence at the same time.


Historical Application of Section 1031 and Section 121


Prior to a recent ruling by the Internal Revenue Service, it was widely believed that the last use of the property at the date of sale determined what tax advantages were available to the taxpayer.


For example, if the property was held, treated and reported as the taxpayer’s primary residence at the time of sale it was thought that the only option was to take advantage of the 121 Exclusion, even if the property had been held as investment property previously. And, alternatively, if the property had been held and treated as the taxpayer’s primary residence in the past, but was actually held as investment property at the date of sale it was thought that the taxpayer had to decide whether to elect the 121 Exclusion treatment or the 1031 Exchange treatment, but not both.


The taxpayer could elect both a 121 Exclusion and a 1031 Exchange if the property was used or held as investment property and as a primary residence concurrently at the date of sale. In fact, if the property is considered to be a single dwelling/structure (i.e. a single family residential property), the taxpayer could elect a 121 Exclusion for the entire property even if the property was partially held as investment property.


Tax and Financial Planning Challenges


These issues can present significant income tax and financial planning issues for taxpayers that have properties with significant capital gains.


Taxpayers that own a primary residence that was acquired 25 years ago with a low cost basis that is now worth millions of dollars cannot get much in the way of tax relief from a 121 Exclusion, and up until now converting the property to investment property would have eliminated the taxpayer’s ability to use the 121 Exclusion.


The Department of the Treasury surprised the investment community and issued a ruling that defines and clarifies the application of Section 1031 and Section 121 on the sale or exchange of a single property.


Revenue Procedure 2005-14


The Department of the Treasury and Internal Revenue Service issued Revenue Procedure 2005-14, which provides taxpayers with some incredible new tax and financial planning options.


The Revenue Procedure provides guidance on the application of Section 1031 and Section 121 to a sale, exchange or disposition of a single property that satisfies the requirements for both the exclusion of gain from the sale, exchange or disposition of a primary residence under Section 121 and the nonrecognition of gain on the exchange of like-kind properties under Section 1031.


Taxpayers who may exclude capital gain from a sale, exchange or disposition of a primary residence may also benefit from a deferral of gain from a like-kind exchange with respect to the same property. In such cases, the property must have been held, used and treated consecutively or concurrently as a primary residence and as an investment property or used in a trade or business.


Combining Section 1031 and Section 121


The Internal Revenue Service was extremely kind in this Revenue Procedure.


Section 121 is applied to gain realized by the Taxpayer first before Section 1031 is applied to any portion of the sale, exchange or disposition of the property.


Depreciation recapture income tax liabilities can not be excluded under Section 121, but certain depreciation recapture may be deferred pursuant to Section 1031.


Cash boot or other non like-kind property (boot) received as part of the sale, exchange or disposition of the property would be allocated to the tax free component of the transaction under Section 121 first, and only the cash boot or other non like-kind property (boot) received in excess of the gain excluded pursuant to Section 121 would be allocated to the investment property component of the transaction and treated as taxable boot received pursuant to Section 1031.


Examples from the Revenue Procedure


Examples are available upon request or can be viewed by downloading Revenue Procedure 2005-14


Revenue Procedure Retroactive


Revenue Procedure 2005-14 is effective January 27, 2005, but can be applied by Taxpayers to taxable years for which the period of limitations for refunds or credits have not expired pursuant to Section 6511.


Tax, Legal and Financial Advisors


This is a tremendous tax and financial planning opportunity that many taxpayers should take advantage of. However, taxpayers should only structure these transactions after consulting with competent tax, legal and financial advisors.