1031 Exchange Case Study: Principal Residence Exclusion & Extenuating Circumstances

Recently we had a client who was selling their house that they had lived in for less than 2 years. They had about $100,000 in capital gains on the home after expenses. This taxpayer wanted to consider a 1031 exchange and was wondering if it was possible.

Principal Residence Exclusion

A 1031 exchange may not be an option in this case if the house has been used as the taxpayer's principal residence. For the IRC 1031 to qualify, you need to HOLD the replacement property for business or investment purposes.

It’s your home and generally speaking, you can't do a 1031 exchange on your home. That's usually not a big deal because under IRC section 121 the principal residence exclusion you get to take up to $500,000 of that profit tax return married filing a joint tax return or $250,000 for single filing.

Extenuating Circumstances

But what if you must move early (prior to the two year period) because of:

• Job related circumstances?

• Health reasons?

• Or other unforeseen circumstances?

You may still be able to take a portion of the two year exclusion if any of the following apply.

121(c)(2) EXCLUSION FOR TAXPAYERS FAILING TO MEET CERTAIN REQUIREMENTS:

(2) Sales and exchanges to which subsection applies. This subsection shall apply to any sale or exchange if:

(A) subsection (a) would not (but for this subsection) apply to such sale or exchange by reason of--

(i) a failure to meet the ownership and use requirements of subsection (a), or

(ii) subsection (b)(3), and

(B) such sale or exchange is by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances.

Contact CPEC1031, LLC

Contact us today with any questions you have about your 1031 exchange. Our team of qualified intermediaries is on hand to guide you through the process and make sure your exchange is set up for success. You can reach us at our primary office in downtown Minneapolis.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2022 Copyright Jeffrey R. Peterson All Rights Reserved

2 Important Things to Know About 1031 Exchanges of Principal Residences

Oftentimes taxpayers ask me:

“I don't qualify for the personal residence exclusion because I haven't lived in the property for two of the preceding five years, but I still want to defer the gains. Can I do a 1031 exchange with my principal residence?”

The 1031 Exchange Qualified Purpose Rule

The answer is no. In order to qualify for 1031 you must have held the property for investment or business purposes. The fact that you've lived in the property and are residing in the property is antithetical to holding it for investment or business purposes. If people don't qualify for the principal residence exclusion and they want the tax deferral they may want to structure their transaction so that they rent the property out for a few years to rehabilitate it as a business or investment property and then it can qualify for 1031.

CPEC1031

If you have any other questions relating to 1031 exchanges, don’t hesitate to reach out to our qualified intermediaries for assistance. CPEC1031, LLC has been facilitating 1031 exchanges of real estate for more than two decades. Our intermediaries can walk you through the entire exchange process and make sure you’ve got all your bases covered. Contact us today at our downtown Minneapolis office to learn more about our services and how we can help!

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

Explaining The Principal Residence Exclusion as it Relates to 1031 Exchanges

Many people that are selling a duplex, triplex, or property that they've lived in as their principal residence will be able to avail themselves of two important tax code provisions.

What is the Principal Residence Exclusion?

The first is the principal residence exclusion, which allows you to take up to $500,000 tax free if you're married filing a joint tax return, or $250K if you're single, and exclude that portion of the gain that relates to your relinquished property.

So on the sale of a duplex, half of the relinquished property that the owner occupied, that portion of the proceeds would be eligible for the exclusion. The other half of the duplex may be eligible for section 1031 where we can defer the gain.

Keep the Allocation Consistent

Now the portion of the proceeds that relates to the rental side, the gains are only deferred. The important thing to remember is that however you've treated that duplex or triplex in the past, in allocating the business and depreciation and portion of the property that you treat it as a rental, you want to stick with the same allocation when you go to sell the property. So whatever allocation you made in the past should be consistent with your split of the proceeds when you sell this duplex or triplex.

1031 Exchange Resources

For more information on 1031 exchanges of real estate, don’t hesitate to reach out to the qualified intermediaries at CPEC1031. We have decades of experience facilitating exchanges of all shapes and sizes and can help you defer capital gains on your next transaction.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

Converting 1031 Replacement Property into a Principal Residence

Many people ask about the possibility of converting a 1031 replacement property into a principal residence. That’s our topic for this article.

If you later sell the hypothetical replacement property, now as your principal residence (IRC Section 121), you and your spouse may be able exclude up to $500K ($250 single), but the Section 121 principal residence exclusion applies only to the taxes on the appreciation in value, and will not exclude gains from the past deprecation (on the current property or the old property exchanged out of). So deprecation recapture will cause some tax inefficiency at the sale of the principal residence.  Also, you have to wait five (5) years before to take a principal residence exclusion on a property that you 1031 exchanged into.

26 USC 121(d)(10) Property Acquired in a Like-Kind Exchange

If a taxpayer acquires property in an exchange with respect to which gain is not recognized (in whole or in part) to the taxpayer under subsection (a) or (b) of section 1031, subsection (a) shall not apply to the sale or exchange of such property by such taxpayer (or by any person whose basis in such property is determined, in whole or in part, by reference to the basis in the hands of such taxpayer) during the 5-year period beginning with the date of such acquisition.

The amount of the exclusion that you get to take also depends on the ratio of time that you used the property of rental (non-qualified use for 1031) and the period of time that you used the property as your principal residence (qualified for 121).

26 USC 121(b)(5)(B) Gain Allocated to Periods of Nonqualified Use

For purposes of subparagraph (A), gain shall be allocated to periods of nonqualified use based on the ratio which—

(I) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to

(ii) the period such property was owned by the taxpayer.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2020 Copyright Jeffrey R. Peterson All Rights Reserved

Combining Both Principle Residences & 1031 Exchanges

Per Revenue Ruling 2005-14, partially nontaxable exchanges are allowed under Section 1031 of the Internal Revenue Code for the portion of the real property used for investment or business purposes.  See IRS Publication 544. 

If, in addition to like-kind property (used for used for investment or business purposes), you also dispose of non-qualified property (not used for investment or business purposes), then you must recognize gain or loss on the non-qualified property you sell. The gain or loss is equal to the difference between the fair market value of the non-qualified property and the adjusted basis of the non-qualified property. This portion of the gain may nevertheless be excluded under Section 121 of the Internal Revenue Code for principle residences. Both Sections 1031 and 121 may be applied to the same sale transaction.

Minnesota Qualified Intermediaries

 At CPEC1031, we give each of our clients the individualized attention that they deserve. Our intermediaries have twenty years of experience facilitating 1031 exchanges in the Twin Cities, and throughout the United States! We’ve got all the resources needed to make your 1031 exchange a reality. Reach out to our qualified intermediaries today at our office in downtown Minneapolis.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2019 Copyright Jeffrey R. Peterson All Rights Reserved