Use Both IRC 1031 & 121

How to apply Rev. Proc. 2005-14

Here’s a quick general summary of how the IRS treats the sale of a house that has been used both as a primary residence and an investment property.

IRS Code section 121 states that in most circumstances the taxpayer doesn’t have to pay taxes when he sells a house that has been used as a home. But first, the house must be the taxpayer’s personal residence. Second, the house must have been the taxpayer’s principal residence for at least 2 years during the last 5 years prior to the sale. And third, the gain on the house must be less than $250,000 for an individual or $500,000 for a married couple who file a joint tax return.

IRS Code section 1031 deals exclusively with investment property. It allows for the deferment of taxes when the investment property is exchanged for another investment property called a “like-kind” exchange. Unlike section 121, section 1031 does not place a limit on the amount of taxes that may be deferred where there is a “like-kind” exchange.

Previously there was some confusion as to how the IRS would characterize a house that had been used both as a primary residence and as investment property. On February 14, 2005 the IRS eliminated the confusion when it published Rev. Proc. 2005-14, which states that sections 121 and 1031 both apply.

REV. PROC. 2005-14 addresses how the taxpayer should determine the computation of gain, and provides three guidelines stated as follow. First, section 121 must be applied to gain realized before applying section 1031. Second, section 1031 may apply to depreciation deductions and third, cash or other non-like kind property (boot) received is taken into account only to the extent the boot exceeds the gain excluded under section 121.

 REV. PROC. 2005-14 also provides a determination as to the computation of basis.

REV. PROC. 2005-14 gives 6 examples of the application of both section 121 and 1031. Some of the examples provided involve (1) the taxpayer who uses a house first as a principal residence, then as a rental and later exchanges it for cash and a townhouse he intends to rent to tenants; (2) the taxpayer buys one lot with a house and guest house, he lives in the house and uses the guest house for an office and exchanges them for 2 different properties – a house and an office; (3) the taxpayer owns one house where he uses 2/3 of it as his house and 1/3 of it as his office and then later exchanges it for a residence and separate property he intends to use as an office.

Of course, the above information is a general summary and many of the complexities involved in section 121, 1031 and Rev. Proc. 2005-114 were not addressed. For your situation, an accountant and/or attorney should be consulted for accurate, specific, pertinent advice.


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