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Primary Residences and Capital Gains
A tax payer’s ability to exclude and/or defer capital gains tax liability from the sale of a primary residence can be a powerful tool and deserves serious attention. Those gains, if dealt with properly could be used to significantly increase an investor’s cash flow and ultimately its net worth.
Most homeowners do not consider a 1031 exchange when selling their primary residence and the ones that do, after a cursory investigation might surmise that the gain from the sale of a primary residence does not qualify for a 1031 exchange.
There are two ways that a residence can be involved in a 1031 exchange. The first is an investor buying a residence under a 1031 exchange as investment property and later converting it to their primary residence, the second is an investor buying a residence as their primary residence then converting it to an investment property to be sold under 1031 exchange.
Revenue Procedural Code, Section 121 is the main way that homeowners deal with any gain on the sale of their home. It allows homeowners to exclude up to $250,000 ($500,000 for married couples filing joint tax returns) of the tax obligation incurred from a capital gain as a result of the sale of their home and up until a few years ago those amounts were sufficient to cover any gain.
Since the price of residential property has increased to a point that homeowners are incurring gains in amounts much higher than $250,000 or even $500,000, creating an excess (more than the exclusion allowed in Section 121) and what appears to be an unavoidable tax liability, combining Sections 121 and 1031 is being looked at more closely.
The requirements to qualify for a Section 121 Exclusion are that the taxpayer must have owned the property for the past 5 years and lived in it for a minimum of two years of those 5 (not necessarily consecutively). The Section 121 exclusion can only be used every two years. Unfortunately, properties categorized as Primary Residences alone do not qualify for a 1031 tax deferred exchange.
The requirements to qualify for a 1031 Exchange are that the property to be exchanged (relinquished) must be used in the seller’s trade or business and/or for investment at the time of the sale. The replacement property (the one to be purchased) must be of “like kind” meaning to be used in the Buyer’s (was the Seller) trade or business or held for investment. Any property being held in this fashion can be depreciated and the investor will be obligated to pay or be permitted to defer depreciation recapture and capital gains taxes upon its disposition or exchange.
Multi Use Properties: Many homeowners and investment property owners have converted their primary residence into investment property and vice versa; additionally business owners are increasingly converting primary residences into a “multi-use” property by allocating a portion of it for use as a home office (business or trade).
Careful planning is required to insure that the property that has been or will be converted to or from a Primary Residence or Business/Investment property in order to qualify for both the tax exclusion of Section 121 and the deferral of Section 1031.
As in all tax matters it is important for the investor to consult with their real estate attorney or tax advisor before making a final decision.Top of Page