Properties with significant personal use by their owners generally do not qualify for a Section 1031 Exchange.  To qualify for a Section 1031 Exchange, the regulations require that properties be ‘used in a trade or business, or held for investment.'  For property owners who sell their principal residences, however, the tax code, through the Section 121 Exclusion, provides the means to reduce or eliminate the capital gains tax liability associated with the sale. 

Subject to meeting the ownership and occupancy requirements noted below, the Section 121 exclusion allows property owners who file an individual tax return to exclude from capital gains taxes up to $250,000 of gain when they sell their principal residence; owners who file a joint return may qualify for $500,000 gain exclusion. 

Please note that the applicable exclusion applies to principal residences only, it does not apply to second or vacation homes.  Please see our webpage titled Second Homes for some important information on how a second home can be converted over time to qualify for a Section 1031 Exchange.


Requirements to Qualify

To qualify for the Section 121 exclusion, taxpayers must meet the following criteria:
 

-As of the date of sale, the property must have been owned and occupied as a principal residence by the taxpayer for an aggregate of two of the prior five years.  The required 24 months of occupancy need not be consecutive. 

 

-In the case of a husband and wife filing a joint return, the exclusion will apply if either spouse satisfies the ownership requirement.

 

-If the residence is received from a former spouse in a divorce or separation proceeding, generally the ownership of and use by the former spouse will, subject to certain limitations, be attributed to the taxpayer.

 

-If the failure to meet the two year period is attributable to changes in employment, health, or other unforeseen circumstances, then a proportionate part of the exclusion will apply, which proportion is based generally on the percentage of the two year requirement met.

-If spouses own and occupy a dwelling as their principal residence, and one spouse dies, the surviving spouse may still qualify for the Section 121 exclusion provided that the sale of the residence occurs 'not later than two years after the spouse's death, as long as the requirements for the $500,000 exclusion were met immediately before the spouse's death and the survivor has not remarried as of the sale.'  This provision was effective as of January, 2008.

 

 

Limitations

 

There are a number of limitations on the availability of the Section 121 exclusion:

 

-Two Year Limitation. The exclusion can be taken as often as once every two years; however it cannot be claimed on the sale of any principal residence that occurs within 24-months of the property sale date for which the exclusion was claimed.

 

-Depreciation Recapture. Any depreciation deductions taken on the residence after May 1997 will be recaptured and gain recognized; the Section 121 exclusion cannot be applied against depreciation recapture.

 

-Not Applicable to Expatriates. The exclusion does not apply to any gain recognized by expatriates who are deemed to have so expatriated to avoid U.S. taxation within the meaning of Section 877 of the Code. 

 

Planning Opportunities to Help Minimize Gains Taxes

 

Depending upon the nature of the residence, the use of the property, or the circumstances of the sale, there may be planning opportunities in combining the benefits of the Section 121 exclusion with a Section 1031 exchange.  This includes:  

The sale of a two-family home, wherein the owner rents one unit and occupies the other as his principal residence.  When this property is sold, the rental unit may qualify for a Section 1031 Exchange, while the owner occupied unit would qualify for the Section 121 exclusion, provided that the taxpayer meets two-year ‘owned and occupied’ standard.

 

A property owner may move out of his principal residence and rent the property to a tenant for two years, then sell the property.  This sale may qualify both for the Section 121 exclusion – it was owned and occupied by the taxpayer for two of the prior five years; and it also may qualify for a Section 1031 exchange – it was rented for the most recent two years prior to the sale.

 

Generally speaking, the Section 121 exclusion is applied first to gain realized, while the remaining gain, if any, can be deferred through a Section 1031 exchange.  Please refer to Rev. Proc. 2005-14 for additional information on this subject.
 

Summary

 

Although principal residences do not qualify for Section 1031 exchanges, the Section 121 Exclusion can minimize or eliminate the capital gains tax liability when taxpayer sells his principal residence.  There are ownership and use requirements in order for homeowners to qualify for this exclusion. 

Please visit our Section 1031 Library for additional information on the tax aspects of selling a principal residence.

 

Second or vacation homes do not qualify for the Section 121 exclusion, and second homes with significant personal use may not for a Section 1031 Exchange.  

 

We invite you to call us when considering the sale of real property.  We will be pleased to review with you your options for maximizing the tax benefits under Sections 121 or 1031 that may apply to your circumstances.