Money Management - January 2006

IRS Allows 1031 Exchange

For Business Use Of Primary Residence

by Shauna Brennan Erhard

For years, Internal Revenue Code (IRC) §121 would let you exclude income tax on the profit of your primary residence, provided you satisfied certain requirements. And under §1031, investors and business owners have been able to defer capital gains tax when exchanging investment or business property.

IRS Rev-Proc 2005-14 lets you combine the two code sections. You can now take the §121 primary residence tax exclusion and also the §1031 tax deferral when you exchange certain business and investment property.

Primary Residence Exclusion

Section 121 lets you exclude gain on the sale or exchange of a home, if you owned and occupied it as a principal residence for at least two of the five years ending on the date of sale or exchange. Individuals can exclude $250,000 and couples filing jointly can exclude $500,000. But any gain due to depreciation adjustments after May 6, 1997, such as recapturing home office or workshop depreciation, doesn’t qualify. If you acquired your home in a §1031 investment property exchange and converted to a primary residence, the §121 primary residence exclusion only applies if you sell it at least five years after you acquired it.

Investment Property Tax-Deferred Exchange

The §1031 tax-deferred exchange applies to property held primarily for productive use in trade or business, or for investment. Some people combine business use with their primary residence, such as a primary residence converted into a rental property, or a single building used as both a primary residence and as a home office or business. This made it hard to satisfy the "primary business purpose" requirement for a §1031 exchange.

If you primarily use your property in business or as an investment, you need to satisfy other requirements and timelines to qualify for a §1031 tax-deferred exchange:

You have to exchange the property for like-kind property, such as investment real estate for investment real estate, or heavy equipment for heavy equipment. The original property is called relinquished property and the new property is called replacement property. Whichever name you hold title to the original property in, the replacement property must be in the same name.

The market value of the replacement property, plus the debt carried on it, can’t be less than that of the relinquished property. And once the relinquished property closes, you have 45 days to identify the replacement property. You have to close on it either within 180 days or when your federal income tax return is due, whichever comes first. And you can’t legally hold or control the proceeds during the exchange. A qualified intermediary holds all proceeds during the exchange.

Any non-like-kind property you receive in an exchange, such as cash, is called boot. Boot is taxable to the extent of recognized capital gains.

Combination of Exclusion with Exchange

Under Rev-Proc 2005-14, §121 is applied first to gain. Then, §1031 is applied to gain and depreciation deductions allocated to your property’s business or investment portion. Boot is only taxable to the extent it exceeds the gain excluded under §121.

There are three ways you can take the primary residence exclusion while also deferring the gain when you exchange business and investment property. Specifically, if you: converted your primary residence to a rental property or business; own a property with multiple buildings, one of which is your personal residence while the rest are business or rental properties; or operated a business from your primary residence.

And that’s how you combine §121 with §1031. Talk to your accountant about how this applies to you.