Interaction Between Section 121 Exclusion (Sale of Personal Residence) and Section 1031 (Like-Kind Exchange Rules).
A. Rev Proc. 2005-14 provides guidance on the interaction between Sections 121 and 1031 to a single exchange of property.
B.
Section 121 provides that a taxpayer may exclude gain realized on the
sale or exchange of property if the property was owned and used as the
taxpayer?s principal residence for at least 2 years during the 5-year
period ending on the date of the sale or exchange.
1. The amount of the exclusion is limited to $250,000 ($500,000 for certain joint returns);
2. Any gain attributable tot depreciation for periods after May 6, 1997, is not eligible for the exclusion.
C.
Effective for sales or exchanges after October 22, 2004, the American
Jobs Creation Act of 2004 provides that, if a taxpayer acquired
property in an exchange to which Section 1031 applied, the Section 121
exclusion will not apply if the sale or exchange of the property occurs
during the 5-year period beginning on the date of the acquisition of
the property.
D.
A taxpayer who uses a portion of a property for residential purposes
and a portion of the property for business purposes is treated as using
the entire property as the taxpayer?s principal residence for purposes
of satisfying the 2-year use requirement if the residential and
business portions of the property are within the same dwelling unit
[Section 1.121-1(e)].
1.
The term "dwelling unit" has the same meaning as in section
280(A)(f)(1), but does not include appurtenant structures or other
property.
2.
If, however, the business portion of the property is separate from the
dwelling unit used for residential purposes, the gain allocable to the
business portion of the property is not excludable unless the taxpayer
has also met the 2-year use requirement for the business portion of the
property.
E.
For purposes of determining the amount of gain allocable to the
residential and business portions of the property, the taxpayer must
allocate the basis and the amount realized using the same method of
allocation the taxpayer used to determine depreciation. (i.e.,
allocation based on square footage of the residential and business
portions of the property is an appropriate method of allocating the
basis and the amount realized).
F.
Section 1031 provides that no gain or loss is recognized on the
exchange of property held for productive use in a trade or business or
for investment (relinquished property) if the property is exchanged
solely for property of like kind (replacement property) that is to be
held for productive use in a trade or business or for investment.
1.
If a taxpayer also receives cash or property that is not like-kind
property (boot) in an exchange that other wise qualifies under section
1031(a), the taxpayer must recognize gain to the extent of the boot.
2.
The basis of the replacement property is the same as the basis of the
relinquished property, decreased by the amount of cash received and
increased by the amount of gain recognized by the taxpayer in the
exchange.
3. Note ? Section 1031 does not apply to property that is used solely as a personal residence.
G.
Although neither Section 121 nor Section 1031 addresses the application
of both provisions to a single exchange of property, regulations
released in December 2002 address the interaction between involuntary
conversion under Section 1031 and the exclusion under Section 121; Rev.
Proc. 2005-14 generally follows the same principals as explained below.
H.
Taxpayers who exchange property that satisfies the requirements for
both the exclusion of gain from the exchange of a principal residence
under Section 121 and the non-recognition of gain on the exchange of
like-kind properties under Section 1031 may apply both the exclusion of
gain and the non-recognition of gain by applying the following four
procedures set forth in Rev. Proc. 2005-14.
1. Application of Section 121 before Section 1031: Section 121 must be applied to gain realized before applying Section 1031.
2.
Application of Section 1031 to gain attributable to depreciation; The
Section 121 exclusion does not apply to gain attributable to
depreciation deductions for periods after May 6, 1997, claimed with
respect to the business or investment portion of residence; however,
Section 1031 may apply to such gain.
3.
Treatment of boot: Cash or other non-like property (boot) received in
exchange for the relinquished business property is taken into account
only to the extent the boot exceeds that gain excluded under Section
121 with respect to the relinquished business property.
4.
Computation of basis: In determining the basis of the replacement
business property, any gain excluded under Section 121 is treated as
gain recognized by the taxpayer; thus, the basis of the replacement
business property is increased by any gain attributable to the
relinquished business property that is excluded under Section 121.
