1031 Exchange Opportunities – What Are You Selling & What Do You WANT It to Be? 121 vs. 1031
While many individuals buy their first homes for investment purposes, a primary residence still does not qualify for a 1031 exchange as “investment property.” The IRS created Section 121 to provide a tax savings for people selling their primary residence.
Section 121 allows an individual to sell his/her residence and receive a tax exemption on $250,000 of the gain as an individual and $500,000 as a married couple. To be eligible for this tax savings, the home must be held as a primary residence for an aggregate of 2 of the preceding 5 years.
It is possible to combine both Section 121 and Section 1031 on a primary residence under specific circumstances. Examples of these circumstances include:
- A working farm containing the farmer’s residence—the working farmland falls under Section 1031 and the farmer’s house falls under Section 121.
- A duplex or similar plex with one unit being owner occupied (Section 121), the balance held as investment with tenants (Section 1031).
- A residence (Section 121) containing a home office or land that could be partitioned (Section 1031).
David Moore: Hello, David Moore with Equity Advantage and we’re going to talk about what you’re selling today, so I’m going to put it out to you, what do you think it is and what do you really want it to be? And the reason I throw that question out there is, we’re in a sort of a strange world right now, just with inflation, everything else that’s going on.
Yes, once again, it’s May of 2022, and yet again, here we are fighting for 1031 survival, although nobody in our industry is really taking that threat seriously. Once again, the Biden administration has proposed is a cap on an individual’s ability to defer gains at a half million dollars per person per year.
David Moore: I think that half million really sort of floats back to 1997 with Sections 121, the $250,000 or $500,000 exclusion. And otherwise, I don’t know how the half million gets to be, but the reason I bring up Section 121, not only just because I think it’s part of that conversation, is that if you look at the $250,000 or $500,000 that was put in place in 1997 and compare that to property values, today, 2022, it’s a totally different world. And I really firmly believe the $250,000 or $500,000 probably ought to be million, million, five or even greater today to offer the same protection the exclusion offered when it came into place replacing Section 1034 in 1997.
So, if we’re looking at what you’re selling, once again, I’m going to ask you, what do you think it is and what do you really want it to be? There are many situations through the years where we’ve taken a property that maybe was a primary residence, and it was converted into an investment at some point in time.
Did you know that as long as if you meet the two out of five that Section 121 covers, that you could be living in a home, you can move out of that home as long as you sold it within three years of moving out, you’re still entitled to Section 121, the $250,000 or $500,000 exclusion? So once again, 121 is not what something is at time of sale, it’s whether it fits a two out of five requirement, and that’s something we’ve done many times through the years.
David Moore: Section 121 also says you can apply it once every two years, that’s not an absolute. You could have multiple sales as part of one transaction. Let’s say you had a house with the adjacent lot, and that lot was your backyard forever.
Well, in today’s world, you’re probably going to break it off and do a 1031 on that piece, just because your gains are probably well in excess of the $250,000 or $500,000 on the sale of your home, which leads me to this. So, we can convert a residence into investment, we can go investment to residence.
One of the big reasons we’re going to look at actually converting a property from a primary residence into investment is to protect you, to keep your money yours. We like to say, you’ve worked hard for your money, we work hard to keep it yours.
David Moore: Now, imagine you’ve got a home that’s got a basis of a half million dollars, and now you’re selling the property and it’s $1.5 million or $2 million, you’re not going to get very far, that exclusion is going to leave you hanging out there to the tune of $1 million, $1.5 million. You’re going to lose at least a third of that to tax. So, you probably don’t want to have that happen.
So what are your choices? Well, you just move out of the house. Treat it as an investment property for a period of time, that period of time is not spelled out in the code, you need to talk to your tax people about this, but you’re just going to move out of that home after you’ve seasoned it as an investment property for what you and your tax people feel is a reasonable period of time, you can then sell it. You’re still entitled to the exclusion, you’re going to 1031 the overage.
David Moore: Now, a lot of times you might say, “Well, gee, I don’t want income property, I don’t want to deal with the terrible Ts: Toilets, trash, tenants, turnover. What do I do?” Well, maybe you just do that 1031 overage and do something called the Delaware Statutory Trust.
So there’s other things out there that can take care of it, but like I said, you’re in a situation, you’ve got a home with gains well in excess of the $250,000,000 or $500,000,000 you don’t want to pay the tax on that transaction, move out of it, convert it to an investment, as long as you sell it within three years of moving out of it, you’re still entitled to the exclusion, you’re going to 1031 the overage.
David Moore: So that’s an example of taking a primary residence go into investment. Now, let’s go the other way. Where is a situation where you might take and convert an investment to your residence?
Well, lots of times people want to go out and buy something at the beach, they buy that property at the beach, they say, “Boy, that beach property is really nice,” they ultimately want to move into it, so we can acquire something via 1031 and after a reasonable period of time, convert it from an investment to residence.
There’s no tax on the conversion, the tax consequence is going to happen upon a future disposition, which leads me to this: If you acquire a property via 1031, convert it into a primary residence, do not sell it within five years of acquisition. If you sell it within five years of acquisition, it’s a fully taxable sale. So, number one, don’t do that.
David Moore: Number two, even if you’ve held it for more than five years, you can be subject to something called the Housing Assistance Tax Act of 2008, and it’s pretty ugly. Alright, and what basically it says, is that you’re only going to be allowed the $250,000 or $500,000 exclusion on a qualified use period.
So, what happens is, from 2009 to the date of conversion, that’s gain attributal non-qualified use. The qualified use is the time you live in it, and you’re going to be allowed that proration based upon the ratio between qualified versus non-qualified use periods. It’s convoluted, talk to your tax people about it. Make sure they know about it. But that rule exists, it’s been here since 2008 now, and we have lots of people that work with that all the time.
David Moore: Bottom line, long story short, look at that transaction, look at the acquisition, conversion of investment to residence as an end game, a place to go. You’re going to be there for the foreseeable future. Don’t look at it as, “Hey, I’m going to do this transaction, I got this great idea, I’m going to buy the property, hold it a year, live in it for two, take the exclusion, have no gain.” It does not work, no longer works, hasn’t worked for a number of years, but still floats around out there as good ideas for people.
If you’ve got further questions on either conversion from a residence into investment or investment to residence, please don’t hesitate to reach out, we’re happy to talk to you about these topics, and we do it all the time. And like I said, we try to keep your money yours, working for you. You’ve worked hard for it, we want it to work hard for you.
David Moore: Once again, David Moore, Equity Advantage, 1031exchange.com. Thanks for joining, bye-bye.
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