Like-kind home exchanges: IRS allows both exclusion and deferral of gains.

Rev. Proc. 2005-4 (IRB 2005-7, Feb. 14, 2005) clarifies that homeowners, who may exclude gain from a sale or exchange of their principal residence, also may defer gain from a like-kind exchange of the same property.

Background

Generally, under IRC Sec. 121, taxpayers may exclude gain of up to $250,000 ($500,000 for certain joint returns) from the sale or exchange of the taxpayer's principal residence. Taxpayers must have owned and used the property as their principal residence for at least two years during the five years preceding the sale or exchange, and must not have used the exclusion during the previous two years.

This exclusion also may apply to a business portion of a home, but not to depreciation for business use after May 6, 1997. This limitation applies only to depreciation allocable to the portion of the property eligible for the exclusion.

Taxpayers using a portion of a property for residential and a portion for business purposes is treated as using the entire property as the taxpayer's principal residence to satisfy the two year use requirement if the residential and business portions are within the same dwelling unit.

Sec. 1031(a) provides that no gain or loss is recognized on the exchange of property held for use in a business or investment (relinquished property) if it is exchanged solely for property of like kind (replacement property) that is to be held for use in a business or investment.

Under Sec. 1031(b), if a taxpayer also receives cash or other non-like-kind property (boot) in an exchange otherwise qualifying under Sec. 1031(a), the taxpayer must recognize gain to the extent of the boot.

Sec. 1031 does not apply to property used solely as a personal residence.

The basis of property acquired in an exchange is its fair market value, unless otherwise provided in the Code [for example, Sec. 1031(d)] or the regulations.

Under Sec. 1031(d), the basis of the replacement property is the same as the basis of the relinquished property, decreased by the amount of cash received and increased by the amount of gain recognized by the taxpayer in the exchange.

Neither Secs. 121 nor 1031 address the application of both provisions to a single exchange of property.

Computing Gain and Basis

(1) Sec. 121 Applied Before Sec. 1031. Sec. 121 must be applied to the gain realized before applying Sec. 1031.

(2) Applying Sec. 1031 to Gain Attributable to Depreciation. Although the exclusion does not apply to gain attributable to depreciation after May 6, 1997, Sec. 1031 may apply to this gain.

(3) Treatment of Boot. In applying Sec. 1031, boot received in exchange for property used in the taxpayer's business or held for investment (the relinquished business property), is taken into account only to the extent the boot exceeds the gain excluded with respect to the relinquished business property.

(4) Computing Basis. In determining the replacement business property's basis, excluded gain is treated as gain recognized by the taxpayer. Thus, the replacement business property's basis is increased by excluded gain attributable to the relinquished business property.

Caution

For sales or exchanges after Oct. 22, 2004, the 2004 American Jobs Creation Act denies the exclusion if the residence was acquired within the previous five years in a like-kind exchange. (Federal Tax column, California CPA, December 2004).

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Example

T, an unmarried individual, buys a single dwelling unit for $210,000. From 2001 until 2006, T uses two-thirds of the property (by square footage) as T's principal residence and one-third as an office in T's business. T claims $30,000 depreciation for this business use.

In 2006, T exchanges this property for a residence and a separate property that T intends to use an office in T's business. These replacement properties' fair market values are $500,000 (residence), $250,000 (business office) for a total of $750,000.

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The tax consequences of this exchange are shown in the box above.

T's basis in the replacement residential property is $500,000, its fair market value at the time of the exchange. T's basis in the replacement business property is $40,000, which is equal to T's basis in the relinquished business property at that time.

Tax Consequences of Exchange Depicted in Example

                     Total Property  2/3 Residential  1/3 Business

Amount realized      $750,000        $500,000         $250,000

Unadjusted basis     $210,000        $140,000          $70,000

Less--depreciation     30,000               0           30,000

 Adjusted basis      $180,000        $140,000          $40,000

Gain realized        $570,000        $360,000         $210,000

Less

 Sec. 121 exclusion  $250,000        $250,000               $0

 Sec. 1031 deferral   210,000               0          210,000

  Total reductions   $460,000        $250,000         $210,000

    Gain recognized  $110,000        $110,000               $0

By Stuart R. Josephs, CPA

Stuart R. Josephs, CPA has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].