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Combining the 1031 exchange with the 121 exclusion rules can be a powerful income tax planning tool available to you.
Section 121 of the Internal Revenue Code provides that property held and used by taxpayers as their primary residence for 2 years out of the last 5 years can exclude up to $250,000 ($500,000 Married Filing Joint) of gain from their taxable income when the property is sold.
With the recent increases in real estate values, many taxpayers are finding themselves with gains of over $250,000, and may have to report additional taxable gains, however there may be an alternative. Rev Procedure 2005-14 allows a taxpayer to move out of their primary residence and convert it to investment property. The question is how long must the property be held as investment property? Most experts recommend renting the property for 1 to 2 years to demonstrate that in fact the property is investment property. Once the property has been held as investment property for sufficient time, the taxpayer can sell the property and qualify for the section 121 tax free exclusion and for a 1031 exchange to defer the balance of the capital gain into more like-kind rental properties. However keep in mind that once you convert the property to investment property, you will need to sell within 3 years, to make sure you capture the 2 years out of 5 years, that you would need to use the property as your personal residence.
On the reverse, if you hold a property that you acquired in a 1031 exchange that has increased in value and are thinking about selling it, you may want to consider converting the property to your personal residence before selling. You will need to hold the exchanged property for a sufficient amount of time to demonstrate that you had the intent to hold the property as investment property, before you can then move in and convert the property to your personal residence. You must live in the property and use as your primary residence for at least 2 years. You will only qualify for a partial tax-free exclusion, however, since part of the property was characterized as “investment” before it was converted to a personal residence. The longer you use the house as your personal residence, the more gain you can exclude.
Both scenarios can be a helpful tax planning strategy if you have highly appreciated property.
If you have any questions, please contact your RINA representative.