Eric Sheldon CPA, PC

Can you have both a primary residence exemption and 1031 exchange on the same property?

Businesswoman With House Model And Stacked Coins On Desk

The short answer is Yes. How to accomplish this should be done with a tax advisor and planning it out to maximize the tax strategy. Please read below to learn more about it.

When you have a property as your primary residence, the only deduction you have available when you sell your property is meeting the two-year minimum threshold and are you able to deduct $250,000 exemption from possible capital gain.
When you have an investment property that you are considering selling, you are looking at options to minimize capital gains. 1031 exchange is the option frequently used to help defer taxes to a later period for an investment property.
The scenario below explores how both primary residence exemption and 1031 exchange was used on the same property.

IRS Rev. Proc. 2005-14.

Question: Jon bought a house for $210,000 and used it as his principal residence from 2010 to 2018. From 2019 until 2021, he rented the house to tenants and claimed depreciation deductions of $20,000. In 2021, he plans to exchange the house for $10,000 of cash and a townhouse with a fair market value of $460,000 that he will rent to tenants. Since Jon used the house as a principal residence for two out of the last five years, can he qualify for both §§121 and 1031?

Answer: Yes. Jon’s example is from Rev. Proc. 2005-14, Example 1, and continues below.
Jon’s exchange of a principal residence that he rents for less than three years, for a townhouse intended for rental and cash, satisfies the requirements of both §§121 and 1031. Section 121 does not require the property to be the taxpayer’s principal residence on the sale or exchange date. Because Jon owns and uses the house as his principal residence for at least two years during the five-year period prior to the exchange, he may exclude gain under §121. Because the house is investment property at the time of the exchange, he may defer gain under §1031.

Under Section 4.02(1) of Rev. Proc. 2005-14, as Jon’s preparer you will apply §121 to exclude $250,000 of the $280,000 gain before applying the nonrecognition rules of §1031. The remaining gain of $30,000 is deferred, including the $20,000 gain attributable to depreciation, under §1031. Although Jon receives $10,000 of cash (boot) in the exchange, he is not required to recognize gain because the boot is taken into account for purposes of §1031(b) only to the extent the boot exceeds the amount of excluded gain.

These results are illustrated as follows:

  • Amount realized – $470,000
  • Less adjusted basis – (190,000)
  • Realized gain – $280,000
  • Less gain excluded under §121 – (250,000)
  • Gain to be deferred – $30,000

Jon’s basis in the replacement property is $430,000, which is equal to the basis of the relinquished property at the time of the exchange ($190,000) increased by the gain excluded under §121 ($250,000) and reduced by the cash he receives ($10,000).

Rev. Proc. 2005-14 has six examples that further demonstrate the interaction of §§121 and 1031. This revenue procedure was issued before nonqualified use was enacted into law. However, Jon escapes nonqualified use because the rental activity took place during the five-year period after he used it as his principal residence [§121(b)(5)(C)(ii)(I)]. Lastly, the instructions to Form 8824, Like-Kind Exchanges, indicate how to fill out Form 8824 using the benefit of the §121 exclusion.

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About the Author

Eric Sheldon

Eric Sheldon

Eric Sheldon is a certified public accountant with more than 25 years of experience in a wide variety of industries. He's the owner/operator of Eric Sheldon CPA, PC, an accounting firm that specializes in providing tax strategy and preparation, accounting, and bookkeeping services to individuals and small business owners.

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