Leveraging 1031 Tax Exchanges with the Principal Residence: Sell Properties in Five Years and Pay No Capital Gains
March 17, 2004
The residential real estate market has been one of the most vibrant sectors of the economy in recent years. Many clients who have sold their principal residence, or who are contemplating such a sale and considering the resulting tax consequences, have been confused by the 1997 amendment of IRC Section 121 allowing taxpayers to exclude certain capital gains on the sale of a principal residence.
The “old” rule was that a taxpayer had two years to purchase a new home with proceeds from the sale of a principal residence in order to avoid paying any tax on the gain. The second part of the “old” rule was that a taxpayer over age 55 had a “once in a lifetime principal residence exclusion” of $125,000.
The “new” rule permits an individual taxpayer to exclude $250,000 of capital gains on the sale of a personal residence (or $500,000 for married couples filing jointly) so long as the residence was occupied for two of the previous five years.
Section 121 defines a “principal residence” based on a facts-and-circumstances test. For instance, to the extent that a taxpayer spends time in more than once residence, the principal residence is considered the residence in which the majority of time is spent. The factors taken into consideration include: the amount of time the residence is used by the taxpayer; the taxpayer’s place of employment; the location where other family members reside; the address shown on the taxpayer’s tax returns, driver’s license and voter registration; and the taxpayer’s connections to the community.
The ownership and use tests need not be concurrent and may consist of 24 months or 730 days. A brief absence, such as a summer vacation, will count as a period of use, but longer absences will not. There is a special exception or “safe harbor” if a taxpayer’s physical or mental capabilities decline making it necessary to reside in an assisted-living care facility. In such cases, when the taxpayer sells or exchanges his or her residence, the gain can be excluded so long as the taxpayer has resided in the personal residence for one out of the prior five years. There is also a safe harbor for the sale of a principal residence where the taxpayer’s physician has recommended a change of residence for health reasons.
“Unforeseen circumstances” resulting in the sale of a principal residence may also serve as the basis for excluding capital gains. Such circumstances include an involuntary conversion of the residence, natural or man-made disasters or acts of war or terrorism, death, cessation of employment, a change in employment or self-employment status, divorce, or multiple births from the same pregnancy.
Under IRC Reg. Sec. 1.121-4(e), the IRS has taken a broad and taxpayer-friendly approach to sales of partial interests and made Section 121 applicable to “such residence” with respect to sales to a related party such as a family member, trust, estate, partnership or family corporation.
Example: Sister Sue is living alone in Boston after the death of her husband and invites Sister Sally who never married to live with her. The home is worth $600,000 and has a $200,000 tax basis (the original purchase price plus improvements). Sally buys from Sue for $300,000 a one-half interest in the property as a tenant-in-common with Sue. Sue is allowed to apply $200,000 of the $250,000 exclusion. Some years later, Sue decides to move to Florida and live with her daughter and sells the remainder of her one-half interest to Sally. Sue is allowed to apply the balance of the $50,000 exclusion remaining on the sale or her retained one-half interest as a tenant- in-common.
The exclusion may also apply to vacant land adjacent to the home if the taxpayer uses the parcel as part of his principal residence, the taxpayer completes a sale qualifying for the exclusion under Section 121 within two years before or after the sale of the parcel, and the land meets the other ownership requirements.
In addition, “mixed use property” may take advantage of Section 121 treatment. If part of the taxpayer’s residence is used for a home office, the exclusion is available. If the office is in a separate structure, it will not qualify unless the structure was used for less than three of the previous five years for non-residential purposes. The exclusion does not apply to the extent to which any depreciation was taken after May of 1997.
The regulations also provide that the exclusion applies to the principal residence when it is held by a grantor trust. Regulation Section 1-121-1(c)(3) is consistent with IRC Sections 671-679, Rev. Rul. 85-13, and 1985-1 C.B. 184 holding that the grantor of a grantor trust is the owner of trust property for income tax purposes. This applies to revocable trusts, income trusts, and trusts in which the grantor has the right to use and occupy property. The ownership requirement is also satisfied with entities disregarded for income tax purposes such as a single member limited liability company. The taxpayer may also combine Section 121 with Section 1031 and create a tax-free sale of mixed-use property. IRC Section 1031 provides for tax-deferred, like-kind exchanges when one property is sold and replaced by another.
Example: Donald and Doreen are married and file joint income tax returns. They own a multi-family apartment complex (complex) and live in one unit as their principal residence. They sell the complex and claim a Section 121 exclusion of the gain on that portion which was considered their home. They buy a new single family home to live in (home A), undertake a Section 1031 tax-deferred exchange for the balance and replace the commercial portion of their property with a second single family home (home B). They rent home B for three years. At the end of these three years, they sell home A and take another section 121 exclusion and then move into home B as their principal residence. When they sell home B two years later, they can take advantage of the exclusion a third time because they made home B their principal residence for two years. Since they are married, the exclusion is up to $500,000 for each of the three sales. If fully leveraged, they could achieve a $1.5 million capital gain with no taxes paid.
IRC Regulation Section 1.121.-2(a)(2) allows unmarried joint owners to qualify for the $250,000 exemption to the extent of their ownership. In cases in which several members of a family have inherited or purchased another family member interests and occupy, the owners should carefully review how the exclusion will apply to their share of the sales proceeds. Consideration may be made to “even up” the ownership so that each party is able to take advantage of the full $250,000 exemption on their share.
For more information, e-mail David Correira at
david.correira@hklaw.com or call toll free, 1-888-688-8500.