The landscape quietly changed for investment property acquired in a 1031 exchange later to be converted and sold as a primary residence by the American Jobs Act of 2004. Internal Revenue Code Section 121(d)(11) was amended per section 840 of the 2004 legislation for the property acquired as replacement property in a 1031 exchange, rented for two years, converted and later sold as a personal residence. The Section 121 $250,000 ($500,000 for married filing jointly) exclusion requires that the property be held for five years beginning on the date of acquisition in the 1031 exchange. The exclusion does not apply to that portion of the gain from the sale of the property that is allocable to periods of “nonqualified use” or time held not as the taxpayer’s principal residence and depreciation recapture.
1031 Exchange and Primary Residence
A 1031 exchange defers the federal and state capital gain and depreciation recapture tax when selling and replacing like-kind real or personal property productively held in a business or for investment. Property that is not eligible for 1031 consideration includes primary residence, inventory, indebtedness, stock and securities and partnership interests. Property held primarily for personal use is not eligible. Vacation property can be held as an investment given a good fact pattern to support the investment intent. Once the vacation property personal use exceeds fourteen overnights per year, the property looks more like a second home and not an investment property.
A vacation property or single family residential investment property can always be converted to a primary residence as supported by the fact pattern of claiming the property on the taxpayer’s federal 1040 tax return as their primary residence and no longer on Schedule E as an investment property. Prior to the 2004 legislation, there was no hold time prior to selling as a primary residence and absorbing the gain via the Section 121 exclusion.
Capital Gain and Section 121 Exclusion
Only the time the property is held as a primary residence is eligible for the Section 121 $250,000 ($500,000 if filing jointly) exclusion. In the example where a rental property is acquired and held as an investment for two years prior to converting to holding as a primary residence for three years prior to selling at the end of year five, 3/5ths of the exclusion is applied to the gain. The denominator reflects the total number of years the property is held and the numerator reflects the total number of years held as a primary residence.
If the property was acquired in a 1031 exchange prior to January 1, 2009, the period of nonqualified use is taken into account to determine the total years of ownership.
If the property was a replacement property in a previous 1031 exchange, then there is a carryover tax basis from the relinquished property. The regulations do not provide direction as to whether the total number of years of ownership is to reflect the years held in a previous 1031 exchange or the total number of years the replacement property was held.
For example, if the property was acquired in 1990 as an investment property and replaced with another investment property in 2010, held two years as an investment prior to converting to a primary and sold at the end of 2015, is the total number of years held in the denominator 25 or five? Typically, the hold time from a prior exchange is “tacked on” to the hold time of the replacement. Is the fraction representing the amount of Section 121 exclusion applied to the gain 3/25ths or 3/5ths? Hopefully, the Internal Revenue Service will provide the answer.
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.
