After using the replacement property for business use or investment, you may convert the property to a personal use property. Generally, under Section 121 of the Internal Revenue Code, if used as a primary residence for at least 24 months within the last five years, you may exclude $250,000 in gain ($500,000 if married, filing jointly). However, under HR 4520 (The Jobs Act) signed into law on October 22, 2004, by President George W. Bush, properties acquired in a 1031 exchange must be owned for at least five years and used at least 24 months of the last five years before allowed to take the Section 121 exclusion. Under Section 121, regardless of whether or not a 1031 exchange was involved, you cannot exclude depreciation recapture from May 6, 1997 forward so some depreciation recapture may be due on the sale.
The Housing Assistance Tax Act of 2008, signed by President George W. Bush on July 30, 2008, includes a modification to the Section 121 exclusion of gain on the sale of a primary residence. This modification affects taxpayers who exchange into a residential property, and then later convert the property to a personal residence.
Effective January 1, 2009, the Section 121 exclusion will not apply to gain from the sale of the residence that is allocable to periods of “nonqualified use.” Nonqualified use refers to periods that the property is not used as the taxpayer’s principal residence. This change applies to use as a second home as well as a rental.
How does this affect 1031 planning? Suppose you exchanged into the property and rented it for three years, and then utilized it as a primary residence for two years. You then sold the residence and realized $300,000 of gain. Under prior law, you would be eligible for the full $250,000 exclusion and would pay tax on $50,000. Under the new law, the exclusion would have to be prorated as follows (the example does not take into account deprecation taken after May, 1997, which is taxable regardless).
- Three-fifths (3 out of 5 years) of the gain, or $180,000, would be ineligible for the $250,000 exclusion.
- Two-fifths (2 out of 5 years) of the gain, or $120,000, would be eligible for the exclusion.
Importantly, nonqualified use prior to January 1, 2009 is not taken into account in the allocation. For example, consider a taxpayer who exchanged into the property in 2007, and rented it for 3 years till 2010 prior to the conversion to a primary residence. If you sold the residence in 2012 after two years of primary residential use, only the 2009 rental period would be considered in the allocation. Thus, only one-third (1 out of 3 years) of the gain would be ineligible for the exclusion.
The allocation rules only apply to time periods prior to the conversion into a principal residence and not to time periods after the conversion out of personal residence use. Thus, if a taxpayer converts a primary residence to a rental, and otherwise meets the two out of five year test under Section 121, the taxpayer is eligible for the full $250,000 exclusion when the rental is sold. This rule only applies to periods after the last date the property is used as a principal residence. Therefore, if the taxpayer used the property as a principal residence in year one and year two, then rented the property for years three and four, and then used it as a principal residence in year five, the allocation rules would apply and only three-fifths (3 out of 5 years) of the gain would be eligible for the exclusion.