One of the hidden benefits of doing a Section 1031 exchange is that the code permits the taxpayer to change the use of the replacement property without triggering a realization of the deferred gain that was accumulated into it!

But, like so many other rules in this area, strict compliance with the guidelines is required.

Remember, all replacement property must be acquired and held for productive use in business, trade or investment. As such a “holding period” is recommended to ensure that the use is consistent with this intention. Some tax advisers counsel a one year hold, while the IRS itself provides guidance that two years is sufficient.

Once the property is held for the requisite time period, the taxpayer may, if they then elect, change its use to a principal residence. But how will the gains analysis be impacted when the property is then sold?

Sales of principal residences under section 121 of the IRC provide generous tax exclusions with respect to payment of capital gains. A taxpayer selling a property that was his principal residence for a combined 24 of the previous 60 months prior to closing is entitled to exclude the first $250,000 of the gain for individuals, and the first $500,000 of the gain for married couples filing jointly. The 24 month period does not need to be consecutive, and it does not need to occur at any particular time within the 60 month look back period.

If the property sold was previously acquired as a replacement property in a 1031 exchange, two additional rules are implicated.

First, taxpayers may only elect to exclude gains on the sale of a “converted” 1031 replacement property under section 121 principal residence exclusion if the property being sold was owned for 5 years or more.

Second, property that was previously used for business, trade or investment is “limited” when using a section 121 principal residence exclusion. The exclusion is reduced pro rata by the number of years it was used for non-principal residence divided by the total years of ownership. But investment use prior to January 1, 2009 is not counted in this reduction, and commercial use after the last date of principal residential use is also not counted.

Let’s take a couple of examples.

Example 1: Bob sells a rental property and properly defers the gain of $100,000 by purchasing another rental unit as a replacement using a 1031 exchange. The replacement property was purchased on January 1, 2008 for $300,000. He uses it for rental use until January 1, 2011, when he begins to use it as a principal residence. He then sells it outright on December 1, 2013 and realizes a total gain of $300,000. Bob is unmarried.

Analysis: Since Bob is selling a property that was his principal residence for 24 of the 60 months prior to the date of sale, he is entitled to use section 121. But since this property was acquired as a replacement property in a 1031 exchange, he is limited to property that he owned for at least five years. Since he owned it for more than five years, he meets this test. However, the amount of the exclusion ($250,000 for single persons) is reduced by the ratio of years of non-qualifying use (the time period the property was rented) divided by the total years of ownership. But non-qualifying use prior to January 1, 2009 is not counted. So the 12 months of rental use in 2008 is not included here, and his non-qualifying use would be from January 1, 2009 until January 1, 2011, or 24 months. His total period of ownership was 71 months. So the exclusion of $250,000 is
reduced by 24/71 or 33.80%. Now he is entitled to exclude $165,492, and must recognize a gain of $134,508.

Example 2: Joy buys a principal residence on January 1, 2007. She lives in it until January 1, 2010, when she then converts it to a rental property. On January 1, 2013 she sells it, realizing a gain of $400,000, and successfully defers the gain by purchasing a 1031 replacement property which she also uses as a rental. Joy is not married.

Analysis: At the time of sale Joy can utilize section 121 since the property being sold was her principal residence for 2 of the 5 years immediately prior to the sale (January 1, 2008 until January 1, 2010). Her exclusion is not limited since the non-qualified use (the rental period beginning on January 1, 2010) occurred after the last date of residential use (December 31, 2009). Thus, she can exclude $250,000 of the $400,000, and the remaining $150,000 is deferred through the successful 1031 exchange.