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Homeowners Exemption and 1031 Exchange

Are you aware that you can utilize the tax advantage of both IRC §§121 and 1031 on the sale of a residence and exclude or defer all of the capital gain?  As we know, $250,000 can be excluded for a single person and $500,000 for a married couple under  §121 if the home has been lived in for 2 of the last 5 years by the taxpayer.  If the home is subsequently rented and converted to a rental, §1031 may be used to defer the additional gain.  This creative technique works as follows:

Example:

Brian and Dana have lived in their California home for 8 years in which they have an existing loan of $400,000.  They purchased it for $600,000 and it has appreciated to $1.8 million dollars.  If they sell the home they will realize a gain of $1.2 million dollars.  With the $500,000 exclusion from gain, they would pay capital gains tax on the remaining $700,000 or about $170,100.

However, they decide to rent their home for a year or two, and utilize §1031 to defer the remaining gain.  Subsequently, they sell it for $1.8 million and exclude $500,000 of the gain under §121.  The equity in the home is $1,400,000.

In order to completely defer $900,000 ($1,400,000 less $500,000 exclusion) Brian and Dana acquire replacement property that is equal to or greater in equity value to the property sold, less the $500, 000 of excluded gain.  In other words, they must invest at least enough equity in the replacement property so that it is equal to the equity received from the sale of their home, $1,400,000, less the $500,000 exclusion.  As a result, they invest $900,000 in another investment property and defer the tax on this gain.

Should they chose, Brian and Dana could later decide to move into this property for 2 out of 5 years and claim it as a residence.  If they sold it, they could once again exclude $500,000 of gain under §121.

The above is only a general example. Individuals should always seek the advice of their tax and/or legal advisors regarding their specific situation.

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