One of the biggest changes in our tax laws affecting §1031 exchanges of real estate was included in the Taxpayers Relief Act of 1997. This new law included a major change in taxation of the primary residence. Effective May 6, 1997, it repealed the old “over 55” exclusion and replaced it with a generous exclusion of gain on the sale of your primary residence up to $500,000 and permitted you to qualify for the full exclusion as often as every two years.

The impact on §1031 exchanges of real estate was profound and opened the door of opportunity for including the primary residence in §1031 exchange transactions.

Section 1031 and the related regulations make it very clear that real estate held for personal use cannot qualify for 1031 treatment. However, sometimes the residence gets involved in an exchange and the subject can get quite complicated. This primer will help you understand more about the tax part of the primary residence when structuring an exchange with primary residence considerations.

For tax purposes, the term primary residence refers to the place in which you principally reside. If you have more than one home, only your principal home qualifies as your primary residence.

Your primary residence includes the dwelling unit and the land it's located on. The land alone, however, is not a residence. If part of the land is sold, but not the dwelling unit, the land sold is not treated as the sale of a residence. For example, Hale lived in a trailer on thirty-nine acres he owned. He sold the land and continued to live in the trailer on the land rent-free for two years. Then he moved into a houseboat that became his residence.

But he never sold the trailer. Since the Tax Court said that since the sale of the land did not qualify as the sale of a primary residence (real estate held for personal use), it was treated as the sale of real estate held for investment, which can qualify for 1031 treatment.

If your personal residence property includes a substantial parcel of land both have appreciated more than your §121 exclusion amount ($250K or $500K), you should consider "carving out" the parcel and treating it as real estate held for investment and qualifying the land for 1031 exchange treatment. 

If any of the land is used for business or held for investment at the time of sale, an allocation of classification must be made.

The IRS and court cases have allowed up to 65 acres of land to be included as part of the residential classification. However, the rules indicate that more acres could be included if the facts and circumstances so warrant.

Caution: Sometimes a series of sales transactions is necessary to sell the property. If part of the land is sold separately, and the dwelling unit is sold as part of the series of sales, all the sales are lumped together and are treated as the sale of a primary residence.

In IRS Letter Ruling 8940061, the taxpayer bought 5 acres of land contiguous to his fifteen-acre primary residence. He cleared and landscaped the 5 acres, making it an addition to his residence. He did not develop the land separately. The IRS said the land was part of his principal residence.

A condominium is treated by the IRS as a primary residence if occupied by you as your primary residence. You receive legal title in fee simple to a unit in the multi-unit building. Also, you get ownership of an undivided interest in the land and common areas with the other owners of individual units. If you use your condominium as your primary residence, and sell it, the rules applying to the sale of your primary residence will apply.

However, if you use your condominium as rental income property, all the rental deduction and income rules apply and it may qualify for 1031 treatment.

The cooperative form of ownership is similar to condominium ownership. Both involve the collective control of certain facilities of the project and common areas. The difference between the two is the way title is held. The condo owner has fee simple title in a specific unit. The development’s facilities and common areas are jointly owned with other condo owners. Under cooperative ownership, a corporation owns the entire residential building. Each “tenant” owns stock in the corporation and leases a particular apartment from the corporation with rights to occupy the apartment as his or her primary residence. The stock owned by the “tenant” is treated by the IRS as the equivalent to ownership of a primary residence.

Selling stock in a cooperative is treated as the sale of your primary residence. However, if you use your cooperative as rental income property, all the rental deduction and income rules apply and it may qualify for 1031 treatment.

The fact you rent out your residence does not necessarily mean the property loses its classification as your primary residence. You must look at the facts and circumstances of each case to determine this. This presents a real danger if the primary purpose of converting your residence to a rental is to qualify for a subsequent 1031 exchange.

Renting out your old residence for a temporary period during the time you are making a serious effort to sell it will not convert it from a primary residence to rental income property. In one case, the taxpayer moved to a new job location. He rented his old residence until it could be sold. Because his main motive was to sell the residence as soon as possible and not hold it as rental property guaranteed the sale would be treated as the sale of a primary residence. This treatment is applied because the residence was held primarily for sale and not for use in the rental business.

If you sell your Old House, you may qualify to exclude all the gain up to $250,000 for singles and $500,000 for couples filing a joint return. This is not a deduction—it’s an exclusion of income. To qualify, you must have owned and used the property as your principal residence for at least two years during the five years before the date of sale. In most cases, the exclusion cannot be used more than once in a two year time period.

Section 121 provides your gross income will not include gain from the sale or exchange of your primary residence if, during the five-year period ending on the date of sale, you have owned the residence and occupied it for periods of time adding up to two-years or more.

The amount of excluded gain shall not be more than $250,000. However, the exclusion limitation is increased to $500,000 for joint returns if:

the husband and wife make a joint return for the taxable year of the sale of the property, and

• either spouse has owned the residence for a least two years during the 5-year period ending on the date of sale, and
• both spouses meet the two year use requirement during the five year period ending on the date of sale, and
• neither spouse is ineligible for the exclusion by reason of the only one sale every two years rule.

The exclusion rule may be used every two years. However, there are special rules permitting use in more than one sale during a two-year period.

Note: The Internal Revenue Code uses the term “sale or exchange.” Since an exchange of your qualified primary residence is treated as a sale and purchase, we will use the term “sale” alone. You can make an actual exchange of your primary residence but the primary residence portion of the exchange will be treated as a sale. If you acquire a primary residence in an exchange, it will be treated as a purchase.

If you make more than one sale during the 2-year period and claimed the exclusion on your tax return, and sell another primary residence within the 2-year period, you cannot exclude the gain from the second sale. You must include the gain in your income. However, there are exceptions to this rule.

If you sold the residence and did not meet the ownership and use tests, you may exclude a reduced amount if you sold the residence due to:

A change in your place of employment.

Health.

Unforeseen circumstances to be determined by the IRS.

The amount of exclusion is the ratio of the number of months you owned and lived in the primary residence multiplied by 24 months. For example, if you owned and lived in the property for 12 months, your ratio would be 12 months/24-months or 50 percent.

Parallel Point 8-1

â Tax Tip – Be sure to apply the exclusion percentage against the actual gain and not the total of the full exclusion - $250,000 or $500,000. In some instances, the difference is significant.

Parallel Point 8-2

You and your spouse sold your Primary Residence in 2000 and excluded the full gain of $400,000 under §121. You purchased and moved into a new Primary Residence the same year. In 2002, after living in your new Primary Residence for 12 months, your employer transfers you to another city. You sell your Primary Residence for a gain of $300,000. Under the exclusion rule, you may exclude up to 12-months/24-months (50 percent) of $500,000 or $250,000

Under the exclusion rules, your taxable gain is $50,000 - the difference between your total gain of $300,000 and the maximum exclusion allowed of $250,000.

If your spouse is deceased, and you are unmarried, the period you owned and used the property shall include the period your deceased spouse owned and used the property before death.

If your spouse or former spouse transfers the property to you, your period for ownership shall include the period the spouse or former spouse owned the property. You will be treated as using the property as your principal residence during any period of ownership while your spouse or former spouse is granted the use of the property under a divorce or separation instrument.

Caution - The success of tax planning strategies for the primary residence is dependent on the classification of the property – both the Relinquished Property and the Replacement Property. If the properties do not meet the qualified property of like-kind tests, the IRS will treat the exchange as a taxable sale. To review this most important topic, see Chapter Three – Qualified Property. The important issue is the property must qualify for §1031 treatment. No game playing. Just saying the property is qualified does not make it so. It’s what you actually use the property for that determines its classification. And you better have substantial records and other proof. If the IRS says the property did not qualify, the burden is on you to prove it did.

Strategy 1 –

Taxpayers have owned and occupied their home as their personal residence for the last six years. If they sold today, they would realize a gain of $345,000. This gain would qualify for the full exclusion under §121 – it’s less than the $500,000 maximim allowed for a married couple. They decide to sell, take their exclusion and move into one of their rentals acquired many years ago.

Taxpayers pay no tax on the sale of their primary residence.

Converting a rental to their primary residence is not a taxable event. They simply report the property as a rental until vacated by the tenants and treat the property as their primary residence when they move in.

So far, so good. But suppose the taxpayers had acquired the rental property via a §1031 exchange and the basis has gone through many adjustments including the lower than market value substituted into the property (See Chapter Twelve) and a reduction in basis from depreciation allowed or allowable since acquisition. Again, no taxable event because the taxpayers have not sold or exchanged the rental property. They merely reclassified it from Rental Income Property to their Primary Residence.

Now let’s take this strategy to the extreme or, as our astronauts would say, let’s push the envelope and take it to the max. Our taxpayers live in and occupy the property for more than two years. Since they meet the two out of the last five years test for both ownership (remember, they owned the property for a long time even before they occupied it as their primary residence), they qualify for the up to $500,000 exclusion if they now sell the property. But wait, you say, what about all that depreciation they took before they moved in? And what about the fact they acquired it in a §1031 exchange with a low substituted basis? Plus the rental appreciated during the time it was held as a rental—not just the time they lived in it. Does all the gain from those factors qualify for §121 exclusion?

The gain on the sale is the difference between the Adjusted Sales Price (Sales Price less Selling Expenses – See Chapter Five) and the Adjusted Cost Basis. The Adjusted Cost Basis of our taxpayer’s residence is the total of these adjustments:

The substituted basis of the property at the time acquired as a rental in the exchange.

Add any improvements made to the property since acquisition to date of sale.

Deduct depreciation allowed on the property since acquisition in the exchange.

What about the gain from all the appreciation—both during the time held as a rental and the time occupied as their primary residence? It all qualifies for the §121 exclusion up to $500,000.

Exception: There is an exception to the rule. It’s simple—any depreciation taken on the property after May 6, 1997 may not be excluded under §121. It is treated as long-term capital gain.

There are two possible effects of this exception. Say our taxpayers had taken depreciation after May 6, 1997, in the total amount of $6,500.00. If their total gain on the sale of residence was $300,000, they could exclude $293,500 of the gain and $6,500 would be recaptured as long-term gain. If their total gain on the sale of residence was $700,000—more than the exclusion limit of $500,000—they could exclude the full $500,000 and the balance of $200,000 would be recognized as long-term capital gain.

Observation: Depreciation of rental income property is deducted against ordinary income during the time the property is operated as a rental. The possible recapture of some or all of this ordinary income as long-term capital is a small price to pay for the substantial savings inherent in this tax planning strategy.

Strategy 2 –

Next to getting shot at and missed, one of the greatest thrills is analyzing a taxpayer’s current situation and working out a tax planning strategy permitting them to make necessary sales and purchase of real estate and get great tax benefits at every step of the way. That’s what happened several years ago when we moderated a round-table for relocation specialists at a national real estate company’s annual convention.

The session lasted about three hours and focused on tax problems faced by military due to frequent and numerous relocations. Two of the agents were working with a military location in Texas and our round-table discussion gave birth to a grand tax planning approach to the client’s situation.

The client was a sergeant in the Air Force and was planning to retire in about three years. In the meantime, he was being transferred again to another base in the U. S. Over the years the sergeant and his wife had bought four homes in various locations, all located near Air Force Bases, choosing to own a home instead of renting. When transferred, they converted their homes to rental property and planned to do the same during this latest transfer. They were thrilled with the latest transfer—the location being exactly where they would like to retire. They wanted to sell the rentals because of the scattered locations and the market value appreciation had peaked.

Client would locate a residence at their new location ideal for them to occupy as their primary residence when they retired in three years. They would enter into a §1031 deferred real estate exchange, selling the first three rentals (Relinquished Property) and buy the new rental property as Replacement Property. The cost of the new rental was more than the total selling price of the three rentals being sold. They were, in effect, trading up. Their current residence would be sold at the time of their transfer and qualified for exclusion of gain under §121. At their retirement, they would convert the rental into their personal residence and live happily ever after.

Here is an outline of the plan:

• All three rentals qualified for §1031 treatment.
• The agents believed all three would sell quickly since military housing in the three locations was in short supply.
• The residential property being acquired by the clients qualified for §1031 treatment since it was classified as being acquired and held as rental income property
• The exchange permitted the sergeant and his wife to use the entire equity of the three rentals to pay towards the new rental. No reductions for capital gains tax if they had sold the properties instead of using the benefits of §1031.
• The nonrecognized gains would substitute into the basis of the new rental but who cared? If the clients were, in fact, to eventually occupy the rental as their primary residence, the tax-free gains would rest with the property and after two years qualify for exclusion under §121 if they ever sold the property as their primary residence.

Is this a great plan, or what? All this plus they get to use §121 to exclude the gain on the sale of their current Primary Residence.

The reason this plan is so powerful is this: It permits the client to make every real estate transaction required by their life plan and not suffer from income tax liabilities It permits them to get maximum financial results from their transactions. This is what good tax planning is all about.

By the way, we followed up with the real estate agents and the clients did successfully complete the plan and are now happily retired right where they wanted to be.

Strategy 3 –

This strategy vividly demonstrates how knowledge of the tax part of the primary residence and §1031 exchanges can be blended with good creative thinking to achieve some fantastic results.

Clients owned a duplex in a beach community. They lived in one of the units and rented the other. Their retirement plans called for cashing out their large equity by selling the duplex. They planned to buy a large apartment house and operate it through a property manager, providing them a nice cash flow to supplement their other retirement income. Their retirement plans did not include buying another Primary Residence since they would be traveling for the next several years. Their financial objective was to accomplish all this maximizing their capital and minimizing their income tax costs. Their plan was really quite simple but you would be amazed at how many people would rush out and sell the duplex without any financial or tax planning.

Here’s the plan:

• Enter into an exchange agreement with a Qualified Intermediary and sell the duplex as part of the exchange.
• The portion of the duplex used as a rental qualifies as Relinquished Property, the portion occupied as their Primary Residence does not.
• The sale of the Primary Residence is a taxable event and reported on their tax return as such.
• Gain on the sale of the Primary Residence qualifies for exclusion under §121—up to a half-million dollars for the married couple.
• The proceeds from the sale of the rental portion of the duplex qualify as Relinquished Property under §1031 and since they are trading-up, no gain will be recognized at the time of the sale.
• The clients can use their full before-tax equity in the rental portion as part of their payment towards the apartment complex they are buying.
• The clients can use all or part of the cash proceeds from the sale of the portion of the duplex qualifying for §121 treatment. If their gain was more than $500,000 on this portion, the cash proceeds would be reduced by the capital gains tax on the excess amount.
• Since the clients will be investing a substantial cash payment into the apartment house, they will generate a positive cash flow from the rentals.

The same rules apply to sale of 4-plex etc. Just make the correct allocation between the primary residence (§121) and the rental portion (§1031).