DID YOU KNOW that you can combine the tax advantages of the home sale tax credit (IRS Code Section 121) and the tax deferral advantage of a like-kind exchange (IRS Code Section 1031)? Section 121 allows a married couple to exclude $500,000.00 of gain from proceeds received from the sale of their principal residence, provided they have owned the property and used it as their principal residence for at least two of the five years prior to the settlement date of its sale. Section 1031 permits the deferral of capital gain from the sale of investment property if the seller purchases “like kind” property of equal or greater value. Based on these rules, a taxpayer may convert appreciated investment property into a principal residence, live in it for two years and thereafter sell the property as a principal residence, thereby eliminating capital gains on the sale of the converted investment property up to the amount of $500,000.00 for a married couple, or $250,000.00 for an individual. Therefore, a taxpayer can (1) sell an investment property; (2) purchase a replacement “like kind” property and defer the gain under Section 1031; (3) convert the replacement property to his principal residence; (4) live in it for two years; and, finally, (5) sell the property and exclude the allowable gain under Section 121, provided that there was no actual, tangible intent to convert at the time of the exchange [step (2) above].
In 2004, Congress amended Section 121 so that if a taxpayer acquiresinvestment property in a tax deferred exchange under Section 1031, andthereafter converts the property into his principal residence, the exclusionfrom gain under Section 121 from the sale of the property will not applyif the sale occurs during the five year period commencing on the date theproperty was originally acquired. As long as the sale of the convertedproperty occurs at least five years after its acquisition as investment property,and as long as the taxpayer has used the property as his principalresidence for two years following its conversion, Section 121 permits thetaxpayer to eliminate $500,000.00 of the gain received. The conversionshould not impact the exchange provided that the seller did not have actual, tangible intent to convert the property atthe time of the exchange. It is thus possible to increase the equity in an investment property by purchasing like kindreplacement property, and continuing to do so, deferring the gain at each transaction, finally converting the appreciatedinvestment property to a principal residence, living in it for two years, and excluding the gain on its sale.
In the case of “mixed use” property (e.g. duplex, farm, adjacent vacant land, home office, home daycare), with properplanning, it may be possible to treat property that would qualify for the home sale exemption as partially investmentproperty and partially principal residence, thereby affording the taxpayer an opportunity to defer any gain realizedbeyond the Section 121 limitation. A sale of a residence may be given split treatment: a portion may be treated as heldprimarily for investment, which portion would be eligible for exchange under Section 1031; and, a portion may betreated as the taxpayer’s principal residence whose gain would be excluded under Section 121. This allocation shouldnot be attempted without the advice of a competent tax advisor.