Real Estate Tax Strategy Combinations: IRC Sections 121 and 1031

Is a part of your home being rented out, or have you started renting out a residence that was previously your home? If so, you may be eligible to combine two different sections of the Internal Revenue Code to both exclude a portion of any gain realized upon sale and to defer any remaining gain.

This article will discuss the Internal Revenue Code (IRC) Sections 121 and 1031 and how both can be used in one transaction under certain circumstances.

Key Takeaways

• IRC Sec. 121 allows single filers to exclude up to $250,000 of gain and joint filers up to $500,000 on the sale of a principal residence used for at least two of the past five years.
• IRC Sec. 1031 defers capital gains tax when investment or business-use real estate is exchanged for like-kind property, subject to a 45-day identification and 180-day closing deadline.
• Taxpayers who own mixed-use properties or who convert a principal residence into a rental property may qualify to apply both provisions in a single transaction.
• Revenue Procedure 2008-16 provides a safe harbor: a dwelling unit qualifies for IRC Sec. 1031 treatment if it is rented at fair value for at least 14 days per year and personal use does not exceed the greater of 14 days or 10% of rental days, over a 24-month period.
• Gain is first allocated to the IRC Sec. 121 exclusion, and any remaining gain may then be deferred under IRC Sec. 1031, provided the taxpayer meets all exchange requirements including equal or greater equity and debt in the replacement property.
• Mixed-use scenarios include multi-unit properties with an owner-occupied unit, home offices, accessory dwelling units, and residences converted to rental use.

What Is a Section 121 Exclusion?

IRC Sec. 121 allows taxpayers filing as “single” to exclude realized gains of $250,000 and taxpayers filing “married filing jointly” to exclude realized gains of $500,000 on a residence that was used as the taxpayer's principal residence for periods aggregating two years or more during the 5-year period ending on the date of the sale or exchange.

In other words, from the date of sale or exchange, if the property was your principal residence for 24 months or more over the past 60 months, you are allowed to exclude $250,000/$500,000 of gain. The 24 months (two years) can make up any part of the 60 months from the date of sale; they do not need to be continuous.

What Is a 1031 Exchange?

IRC Sec. 1031 allows for the deferral of capital gains tax on the exchange of investment or business-use real estate for a “like-kind” property. In simple terms, the gain can be deferred on the exchange of a property (relinquished property) that is used for business or rental use when the “replacement property” will have the same use.

A successful 1031 exchange has strict rules and deadlines, including:

• Identifying the replacement property within 45 days of the sale
• Closing on the replacement property within 180 days of the sale
• Involving a qualified intermediary during the escrow process to hold the proceeds from the sale

Combining a 1031 Exchange With a Section 121 Exclusion

At first glance, these two IRC sections seem mutually exclusive, as Sec. 121 applies to real estate that is your principal residence, and Sec. 1031 applies to real estate that is used for business or rental purposes.

However, this combination is particularly useful in situations where a taxpayer converts a primary residence into an investment property, and for taxpayers who own a mixed-use property. Common examples of mixed-use properties include:

• A multi-unit property where one unit is your principal residence and the other units are rented out
• A home office or portion of a home used exclusively for business
• A guest house, accessory dwelling unit (ADU), or rooms in your home that are being rented out
• A home that was your principal residence in Years 1 and 2 and later was converted to a rental property can also qualify for the mixed-use exclusion, provided that the two years of personal use were within the last five years from the date of sale

Unlike the Sec. 121 exclusion, which explicitly requires two years of personal use, the IRS doesn’t explicitly state how long a residence needs to be rented out for it to qualify for the Sec. 1031 deferral.

However, Revenue Procedure 2008-16 provides a safe harbor that, if met, allows a dwelling unit to qualify as property held for productive use in a trade or business or for investment for section 1031 purposes.

The dwelling unit, whether it’s the relinquished or replacement property, must be owned by the taxpayer for at least 24 months, and in each of the 12-month periods within such 24 months:

1. The dwelling unit is rented to other persons at a fair rental for 14 days or more, and
2. The period of personal use of the dwelling unit does not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

How Is Gain Allocated When Combining Section 121 and Section 1031?

Gain recognized on the sale of the dwelling unit is first allocated to the Sec. 121 $250,000/$500,000 exclusion, and any remaining gain is then deferred under the provisions of section 1031. The taxpayer must comply with the 45-day identification and 180-day closing periods discussed above, and both the equity in the replacement property and the amount of debt must be at least equal to the equity in the relinquished property and the amount of debt to achieve full deferral.

Selling a Mixed-Use or Converted Property? Plan Your Tax Strategy Now.

The window to combine a Section 121 exclusion with a 1031 exchange depends on meeting strict ownership, use, and timing requirements. Getting the sequencing wrong can cost you hundreds of thousands of dollars in avoidable tax. Whether you own a multi-unit property, a home with rental units, or a residence you are converting to investment use, the time to plan is before you list, not after you close.

Contact EisnerAmper's Real Estate Services Group to evaluate your eligibility and structure the transaction for maximum tax savings.