Real and personal property held for stricly personal use does not qualify for a 1031 exchange tax deferral of federal and state capital gains and depreciation recapture taxes. However, property, such as a primary residence converted to a rental and held as an investment property for two years, will qualify for a 1031 exchange. Personal property, including collectibles, vintage cars and artwork, qualifies for the tax deferral given the property is “held for productive use in a trade, business or investment” as supported by maintaining detailed ledgers recording sales and acquisitions, invoices, insurance and expense records.
Internal Revenue Code Section 1031
Section 1031 of the Internal Revenue Code states, “No gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.” The 1031 exchange is effectively an indefinite, interest free loan representing upwards of 40 percent of the initial sale that is not due until the replacement property is sold.
The advantage of a 1031 is the taxpayer can sell income, investment or business property and replace with like kind property without paying federal or state income taxes on the transaction. In addition, the taxpayer has more purchasing power to buy replacement property since the money that would have been used to pay taxes is now available for reinvestment. The disadvantage is there is a reduced basis for depreciation on the replacement property. The replacement property tax basis is the purchase price minus the gain, which is deferred on the sale of the relinquished property. The replacement property includes a deferred gain that will be taxed in the future if the taxpayer sells the replacement property without initiating another exchange.
Internal Revenue Code Section 121
When farms, motels, storage facilities and bed and breakfast businesses are sold, the property consists of a portion used as a primary residence and another portion that is considered “held in the productive use of a business or investment.” That portion of the property held for personal use may be eligible for gain exclusion under Section 121 while that portion allocated as investment may be eligible for gain deferral under Section 1031. Section 121 allows a US taxpayer, regardless of age, to exclude $250,000 filing as an individual and $500,000 for married persons filing jointly on the gain from the sale of their primary residence. The gain exclusion may be taken once every two years given the property was the taxpayer’s primary residence totaling two years or more during a five-year period from the date of sale. If the taxpayer fails to own the property as a primary residence for less than two years, a prorated fraction of the exclusion may be used given unforeseen circumstances such as health and employment, or to the extent provided in the regulations.
Mixed Use
The non-residential portion of the property may qualify for federal and state capital gain and depreciation recapture tax deferral. For example, the land surrounding a farm with a primary residence is “held in the productive use in a trade, business or investment.” The rule of thumb is the grass cut around the personal residence is sold with the house. That portion of the house, motel, storage facility or business that represents the primary is eligible for the Section 121 gain exclusion. The remainder may be eligible for the 1031 exchange tax deferral.
An investment property can be exchanged for another investment property with a residential portion of the replacement property. The settlement statement should reflect that that residential portion is acquired with non-exchange funds and the investment portion with 1031 exchange funds.
When selling a mixed use property, be sure to consider the tax consequences and whether or not a 1031 exchange makes sense. Download the free “1031 Exchange Checklist” to learn what to consider when initiating a 1031 exchange.
