A 1031 exchange allows the taxpayer to defer federal and state capital gain and depreciation recapture taxes when selling and replacing real and personal property held in the productive use of a business or for investment. The tax deferral strategy is not to be used for second homes with greater than 14 overnights of personal use or for those properties held primarily for profit such as flipping. Taxpayers whose income is derived primarily from real estate can utilize the 1031 exchange, but must be careful to hold those properties with the intent (good fact pattern) of investment including time, in a rental pool, limited personal use and separate from their normal business activity. Inventory, indebtedness, stocks and securities, partnership interests and primary residences are not eligible for a 1031 exchange.
Typical 1031 Exchange
A 1031 exchange takes the tact of either a forward or reverse exchange. Each follows the same set of exchange rules. In a forward exchange, the relinquished or old property is closed first, followed by the replacement property acquisition. In a reverse exchange, the replacement property is acquired before the old property is sold. To defer one hundred percent of the recognized gain or tax due, the net purchase price must be equal to or greater than the net selling price. Otherwise, a tax is triggered on the difference in what is referred to as a partial exchange.
Real property must be exchanged for real property while personal property must be exchanged for like-kind or like-class personal property. If the property is located predominately in the US, then the replacement must also be located predominantly in the US. Property held internationally, must be exchanged for property held overseas.
Primary Residence
Section 121 provides a $250,000 ($500,000 for married persons filing jointly) exclusion on the gain given in the five year period ending on the sale date, the property has been owned and used as the taxpayer’s primary residence for two years or more. Should the taxpayer abandon the original residential use purpose and sell as a rental home which was the taxpayer’s primary residence within the past five years and satisfies the Section 121 requirements, a 1031 exchange is not necessary given the amount of the gain excluded is absorbed by the Section 121 exclusion or significantly reduces the taxpayer’s tax. Depreciation taken after May 6, 1997 is not eligible for the gain exclusion.
Convert a 1031 Rental to a Primary Residence
A 1031 replacement property may be held as a rental for two years to later be converted to a primary residence. Section 840 of the American Jobs Act of 2004 amended Section 121(d)(11) such that the taxpayer must hold the property for a five year period beginning on the date of the acquisition of the property in the 1031 exchange. The Section 121 exclusion does not apply to the portion of the gain from the sale for time held for nonqualified use or for rental and depreciation recapture. The exclusion applies to that portion the property is held as the taxpayer’s primary residence. A fraction is created where the denominator represents the total number of years the property and previous property given the property was acquired in previous exchange while the numerator represents the total number of years held as the primary residence. The longer the property is held as a primary residence, the more the gain is absorbed by the Section 121 exclusion.
Review the tax consequences of selling a converted 1031 rental to a primary residence with your CPA. Should you have questions, click here to ask the Certified Exchange Specialist on staff.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
