If you own a property that has been used as both your personal residence and as a rental or investment property, it’s possible to optimize your tax benefits upon its sale by combining a 1031 exchange with a 121 exclusion. This can be particularly advantageous for properties that have appreciated significantly, resulting in capital gains that exceed the limits allowed under Section 121 exclusion.
In this blog post, we delve into each of these tax provisions and discuss possible scenarios that allow you to use both strategies simultaneously.
1031 Exchange for Investment Properties
A 1031 Exchange as defined in Section 1031 of the U.S. Internal Revenue Code, is a valuable tool for deferring taxes that would otherwise be due upon the sale of investment property. This tax-deferral strategy allows real estate investors to reinvest the proceeds from the sale of the relinquished property into another “like-kind” property (in this case, the replacement property) and defer all capital gains taxes. Both properties should have been used for investment, rental, or business purposes.
121 Exclusion for Primary Residence
The Section 121 Exclusion, also known as the primary residence exclusion, is a provision under the U.S. Tax Code that allows property owners to exclude a significant portion of the capital gains from the sale of their primary residence.
If a property owner has lived in their home for at least two of the last five years before the sale, they can exclude up to $250,000 of the capital gains if filing as single, or $500,000 if married filing jointly. This exclusion specifically applies to capital gains from taxable income (not depreciation recapture) upon the sale of a primary residence that has also been used as an investment property.
When Combining a 1031 Exchange With a 121 Exclusion is Possible
Below, we’ve outlined three scenarios that allow investors to combine the benefits of the 1031 exchange with a 121 exclusion.
Rental Property Converted to Primary Residence (No Prior 1031 Exchange)
If the property was bought as an investment and later converted to a primary residence without a 1031 exchange, then upon selling, the owner can potentially apply the 121 exclusion to the portion of the gain that is attributable to the period during which the property was used as a primary residence.
You must move into your investment property and use it as your home for at least 24 months. This period doesn’t need to be consecutive, but it must total at least 24 months within the five years prior to selling the property. Meeting this requirement enables you to qualify for the 121 exclusion, which can significantly reduce your tax liability upon the sale of the property.
However, it’s important to note that the exclusion will be partial. This is because the time the property was used as an investment before its conversion will proportionally reduce the amount of gain that can be excluded.
For example, if you owned the property for ten years, and it was a rental for eight years before you converted it and lived in it for two years, the portion of the gain eligible for exclusion would be calculated based on the fraction of the total ownership period during which it was your primary residence.
Rental Property Converted to Primary Residence (Prior 1031 Exchange)
When a rental property has previously been part of a 1031 exchange, it is still possible to convert it to a primary residence to leverage the benefits of the Section 121 exclusion.
Initially, the property is acquired through a 1031 exchange, which allows the investor to defer capital gains taxes by reinvesting the proceeds from a previously sold property into the new one. The new property, at this stage, is considered an investment property.
After the property is held as an investment for a suitable period, typically 12 to 18 months or more to demonstrate investment intent, the owner can convert the property to a primary residence. During this period, the property should not be part of any rental or business activity. Once converted, the owner must own the property (does not have to live in the property) for at least five years before selling it and qualifying for the 121 exclusion.
Primary Residence Converted to Rental Property
In the final scenario, the property owner holds, lives, and uses the property as a primary residence. According to Revenue Procedure 2005-14 of the Internal Revenue Code, the property owner can move out of their primary residence and convert it into a rental or investment property.
However, it is crucial to demonstrate to the IRS that the property was genuinely intended for investment purposes. This is typically achieved by maintaining the property strictly as a rental or business use property, with no personal use, for a minimum period of 12 months. After meeting this requirement, the property can be sold, allowing you to qualify for the 121 tax-free exclusion and a 1031 exchange and defer the balance of the capital gains.
Secure a 1031 Exchange Loan to Maximize Long-Term Tax Advantages
Both 1031 exchange and the 121 exclusion offer a powerful strategy for real estate investors looking to optimize their tax benefits. However, navigating these tax provisions can be complex and demanding. This is where HCS Equity, a seasoned private hard money lender based in California, steps in – to provide investors with the necessary capital at critical moments.
By securing a 1031 exchange loan from HCS Equity, investors ensure that they meet the stringent timelines of a 1031 Exchange without compromising their eligibility for the 121 exclusion.
Let us guide you through the 1031 exchange process. Contact us today to secure a 1031 exchange loan at favorable rates and with no prepayment penalties.
