After using 1031 replacement property for business use or investment, you can 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, one can exclude up to $250,000 in gain ($500,000 if married, filing jointly). Of course, you may not 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 those who exchange into a residential property and 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.” Non-qualified use refers to periods that the property is used as a primary residence or vacation home and not as one’s principal residence.
How does this affect 1031 planning? Suppose you exchanged into the property, rented it for three years and then moved into it for two years. When selling, you realize $300,000 of gain. Under prior law, you would have been eligible for the full $250,000 exclusion and only have to pay tax on $50,000. Under the new law, three-fifths (3 out of 5 years) of the gain, or $180,000, would be ineligible for the $250,000 exclusion.
Non-qualified use prior to January 1, 2009 is not taken into account in the allocation. 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. So if a primary residence is converted to a rental, and otherwise meets the two out of five year test under Section 121, one 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 property is used 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.
Depreciation recapture is not avoided when taking the primary residence exclusion.
Note that Revenue Procedure 2005-14 allows sellers 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 selling, he can take the full $250,000 exclusion afforded under Section 121 and then defer the rest of the gain and depreciation recapture under Section 1031. This Revenue Procedures provides taxpayers with the best of both worlds and an excellent planning opportunity.