1031 Exchange vs. 121 Exclusion: What's the difference
| December 20, 2023
Real estate is one of the most effective ways to grow your wealth and whether you are selling an investment property or primary residence, nobody wants to pay tax on the appreciated value of the property. Each classification of property ownership is governed by a different section of the tax code, Section 1031 and Section 121, and understanding each section will help investors plan to minimize the tax liability from the eventual sale of real estate. Utilizing either section 1031 or 121, or the combination of the both, is a powerful tax planning strategy for all investors.
Section 1031 — Trade, Business or Investment Property
A 1031 exchange (often referred to as a like-kind exchange or a 1031 tax deferred exchange), allows investors to sell a property held for trade, business, or investment ("relinquished property") and exchange it for a "like-kind" property also to be held for trade, business, or investment ("replacement property") allowing investors to defer federal, and in most cases, state capital gain and depreciation recapture tax liabilities.
Section 1031 does not apply to property held for personal use such as your primary residence, second home or potentially a vacation property (certain requirements must be met for a vacation property to qualify for section 1031).
Section 121 — Primary Residence
Section 121 of the IRC (referred to as the 121 exclusion) allows taxpayers who are selling their primary residence, having lived in it for at least 2 of the last 5 years, to exclude from their taxable income
up to $250,000.00 in capital gains per taxpayer ($250,000 if single, $500,000 if married filing jointly). The 121 exclusion can only be claimed with real property that has been held as your primary residence. It does not apply to second homes, vacation homes, or investment properties except where a combination of a 1031 exchange and the 121 is possible.
The 121 exclusion is only applicable to the capital gains, not depreciation recapture. When there is a property that has been held for a period of time as an investment property and then converted to a primary residence, there are limitations to the 121 exclusion depending on the length of time that a property is held. You can only exclude capital gains from the period of time that you held the property as a primary residence. The depreciation recapture would be recognized in the year the primary residence is sold even if you qualify for the 121 exclusion.
There are many different ways to utilize the benefits of the tax code and with careful planning, investors can take advantage of the benefits of these two sections to maximize the use of their money and investment. Below we have outlined 4 scenarios that help understand utilization of Section 121 and Section 1031 of the IRC.
Scenario 1: Converting a Rental Property to a Primary Residence (No Prior 1031 Exchange)
The first scenario involves a investor who owns a rental property that was purchased with non-1031 exchange funds, which is then converted into a primary residence in order to take advantage of the 121 exclusion.
In order to qualify for the 121 exclusion, the taxpayer has to live in and hold the property as their primary residence for two years prior to the sale of the property. Once the two year requirement is met, the taxpayer would then qualify to claim the 121 exclusion, with some limitations.
Under section 121, the IRS refers to the time a property is held as a primary residence as "qualified use", and periods when it is held for any other purpose as "non-qualified use". When a property is held as an investment property (non-qualified use) prior to the conversion to a primary residence (qualified use), then the amount eligible for the 121 exclusion will be reduced by the amount of gain attributed to the period of time that the property was held as an investment property. The basic formula is as follows:
Years of non-qualified use / by Total years of ownership x Gain = Gain that is not eligible for 121 exclusion (non-qualified gain).
***(Periods of non-qualified use occurring after the periods of qualified use are not included in the calculation of non-qualified gain)
Scenario 2: Converting a Rental Property (acquired in a 1031 exchange) to a Primary Residence
The second scenario is almost identical to the first with the exception that the property was acquired as the replacement property in a 1031 exchange transaction.
In order to maintain the validity of the exchange, the property must be held for at least two years to demonstrate the intent of the purchase was to hold the property for investment purposes prior to the conversion.
After two years, the property is eligible for conversion to a primary residence in order to take advantage of the 121 exclusion. Because the taxpayer utilized a 1031 exchange in the acquisition, the IRS requires that the taxpayer own the property for a minimum of five years, in addition to the requirement that the property is held as a primary residence for two of the last five years prior to the sale in order to qualify for the 121 exclusion.
Scenario 3: Converting a Primary Residence into a Rental Property
The third scenario is the opposite of the first two, with the taxpayer purchasing and holding a property as a primary residence and then converting it to a investment/rental property. One of the main reasons that this strategy would be utilized is when the capital gains on a primary residence exceed the 121 exclusion amounts and the taxpayer would incur a tax liability on the excess capital gains.
Revenue Procedure 2005-14 allows the taxpayer could convert the primary residence into an investment property, and if done correctly, defer the excess capital gains through a 1031 exchange. The requirement is still applicable that the property has to have been held for two of the last five years as a primary residence in order to be eligible for the 121 exclusion, but it will also have to have been held for two years as an investment property to qualify for a 1031 exchange. Once the property has been held for the correct periods of time, the taxpayer can sell the property and claim the 121 exclusion and complete a 1031 exchange with the remaining amount in order to defer the capital gains taxes. This is a great tax planning strategy for primary residences that have appreciated significantly since the time of purchase.
Scenario 4: Sale of a Mixed-Use Property
The final scenario involves a taxpayer that owns a property that is used partly as a primary residence and partly held as an investment property. A common example of this is when a taxpayer owns a duplex or triplex, lives in one unit, and rents the others out to tenants. After years of owning the property, the taxpayer can sell the property and the capital gains would be divided between the primary residence and investment portions of the property. As long as the holding period requirements have been met, the taxpayer would be able to claim the 121 exclusion on the primary residence portion, and then complete a 1031 exchange on the investment portion of the property.
In order to take advantage of the many benefits of section 121 and section 1031, it will take years of planning and diligence to ensure you meet the requirements of both. Working closely with your CPA and tax professionals on your tax planning strategy is highly encouraged and an important way to make sure that you are on track at every step along the way.