Not What It Used to Be:
Converting 1031 Replacement Property to
While converting a replacement property acquired in a 1031 exchange from investment or business use to a primary residence is still frequently done, the strategy no longer provides the same benefits as a decade ago.
In 1997, a revised Section 121 of the Internal Revenue Code, created a great opportunity for those who owned 1031 replacement property and wanted to convert it to a primary residence. Under the Taxpayer Relief Act of 1997, old Section 121 and Section 1034 were repealed. Old Section 121 provided a once in a lifetime exclusion of up to $125,000 of gain when selling a primary residence as long as at least one spouse was over 55 years of age. Section 1034 allowed the rollover of the gain when selling your primary residence as long as you acquired a new one of greater value within two years of the sale of the old primary residence. The Taxpayer Relief Act of 1991 gave us a new Section 121 which provides that if you used it as a primary residence for at least 24 months within the last five years, you may exclude up to $250,000 of gain ($500,000 if married, filing jointly). Of course, you cannot have taken the Section 121 exclusion within the past two years.
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 tax may be due on the sale.
The Housing Assistance Tax Act of 2008, signed by President George W. Bush on July 30, 2008, included 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 “non-qualified use.” Non-qualified use refers to periods when the property was not used as the principal residence. This change applies to use as a second home as well as a rental property.
How does this affect 1031 planning? Suppose a single person exchanged into the residence and rented it for three years. He then converted it to his primary residence and lived there for two years. Next he sells the home and realizes $300,000 of gain. Under prior law, he 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 depreciation taken after May, 1997, which is taxable anyway):
- 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.
Note that non-qualified use prior to January 1, 2009 is not taken into account in the allocation. So let’s suppose he exchanged into the property in 2007, and rented for 3 years till 2010 prior to the conversion to a primary residence. If he sold the residence in 2012 after two years of primary residential use, only the 2009 rental period would be considered in the allocation and 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. If he converts a primary residence to a rental, and otherwise meets the two out of five year test under Section 121, he would be 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 he 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.
Note that Revenue Procedure 2005-14 allows Taxpayers to take both the Section 121 primary exclusion and the Section 1031 tax-deferral assuming the property starts out as a primary residence and meets the qualifications for both. For example, assume a single taxpayer lives in a property as his/her primary residence for at least two years, moves out and uses it as a rental property for two years. When he sells, he can take the $250,000 exclusion afforded under Section 121 and then defer the rest of the gain and depreciation recapture under Section 1031. This is very advantageous when the gain is significantly more than the allowed exclusion.
In summary, a 1031 exchange enables you to exchange an existing business use or investment property for a home that you will eventually convert to a primary residence. Of course, you need to maintain the property as a rental for a period of time to satisfy the requirements of Section 1031 but with a little planning and some patience, you could soon be moving into your dream home but be sure to consider your exit strategy in advance.