Sale of a residence and like-kind exchanges (Part I: this two-part article examines how recent developments in the principal residence exclusion and like-kind exchanges affect mixed personal- and business-use property. Part I describes the basic interaction between Secs. 121 and 1031.).

EXECUTIVE SUMMARY

* Sec. 121(d)(10) and Rev. Proc. 2005-14 control how mixed personal- and business-use property is handled under the principal residence exclusion and like-kind exchange rules.

* In mixed-use property situations, the taxpayer allocates sales proceeds in the same manner as for depreciation purposes.

* Rev. Proc 2005-14 applies the principles of interaction between Secs. 121 and 1033 to interactions between Secs. 121 and 1031.

Two recent developments have brought into sharp focus the interaction between the Sec. 121 gain exclusion for principal residence sales and the Sec. 1031 gain postponement rules for like-kind exchanges. The first is the addition of Sec. 121(d)(10) by Section 840(a) of the American Jobs Creation Act of 2004. That provision makes the Sec. 121 exclusion unavailable for a sale of a residence within five years after it was acquired in a Sec. 1031 exchange. (1) The second development is Rev. Proc. 2005-14, (2) which details how a "mixed use" property (i.e., some use as a principal residence and some use as a business property) is handled under Secs. 121 and 1031.

Both of these developments are discussed in this article. Part I, below, outlines Secs. 121 and 1031 and illustrates the interaction between the sale of a residence and the like-kind exchange rules. Part II, in the December 2005 issue, will describe and illustrate in detail Rev. Proc. 2005-14's principles.

Overview

A single taxpayer who has owned and used a residence as a principal residence for two of the five years prior to its sale may exclude up to $250,000 of the gain from disposition of the property. (3) If a joint return is filed for the sale year, up to $500,000 of the gain may be excluded, if (1) at least one of the spouses owned the property for two of the five years prior to its sale, (2) both spouses used it as their principal residence for two of the five years prior to its sale and (3) neither spouse excluded gain under Sec. 121 from a prior sale within two years of the current sale. (4)

As the property (or a portion of it) may have been rental property some time during the prior five-year period, the Code and regulations have to decide how such mixed use affects eligibility for the Sec. 121 exclusion. There are two types of mixed-use property: (1) a single dwelling unit that was either fully (i.e., entire property rented to tenants) or partially (e.g., a home office) used for nonpersonal use; or (2) a portion of the property separate from the dwelling unit was non-personal-use property. (5)

Mixed-Use Property

Single dwelling unit: Under Regs. Sec. 1.121-1(e)(1), no allocation of gain between the residential and nonresidential portions of a property is required for Sec. 121 purposes if both portions are within the same dwelling unit. (6) In addition, the exclusion generally does not apply to the realized gain to the extent of post-May 6, 1997 depreciation; pre-May 7, 1997 depreciation has no effect on the Sec. 121 exclusion. (7)

Example 1: P, a single taxpayer, acquires a house in 1996, rents it to tenants through 1998, moves into it as his principal residence in January 1999, (8) and sells it in 2005, realizing a gain of no more than $250,000. Depreciation was taken for 1996-1998, but the taxable gain is limited to the depreciation taken after May 6, 1997.

Even though P had occupied the property for all of the six years prior to its sale, some of the gain (equal to the post-May 6, 1997 depreciation) is still taxable. A portion of the gain is also taxable if P lived in the property, but used a portion of it to conduct a law practice and took depreciation after May 6, 1997 on that portion. (9)

Portion of property separate from dwelling unit: In many situations, the property may have a dwelling unit for which the taxpayer meets the Sec. 121 requirements, but he or she may not satisfy the use requirement as to other parts of the property separate from such unit. For instance, the property might have more than one dwelling unit, only one of which the taxpayer occupies as his or her principal residence (e.g., a townhouse with more than one dwelling unit). Or, the property may have a dwelling unit and non-residential-use elements (e.g., a farm with a dwelling unit and various outbuildings used for farming).

In such cases, the taxpayer must allocate the sale proceeds between the portion of the property eligible for the Sec. 121 exclusion and the portion ineligible, under Regs. Sec. 1.121-1 (e) (3). The allocation uses the same method that the taxpayer used to determine depreciation.

Example 2: Y, a taxpayer, owns a townhouse with three dwelling units. He lives in two of them and rents out the third. Y allocates the property's cost based on square footage and depreciates the rental unit. Assuming the rental unit is 35% of the building's square footage, only 35% of the building's cost is depreciable.

Under Regs. Sec. 1.121-1(e)(1), 35% of the sale proceeds are not eligible for the Sec. 121 exclusion when the property is sold. Instead, the sale of that portion is taxed under Sec. 1231. (10) The remaining 65% is allocable to the taxpayer's personal-use residence and, assuming it meets the Sec. 121 requirements, the gain thereon is eligible for exclusion. As the rental portion of the property is separate from the personal-use portion, any post-May 6, 1997 depreciation taken for the rental portion will not affect the Sec. 121 exclusion with respect to the residence. (11)

The remainder of this article examines various situations related to mixed-use property and how the recent tax developments clarify the applicable law. The law is quite generous in "finding" excludible gain under Sec. 121, even under rather unusual circumstances. However, before turning to that discussion, a brief review of Sec. 1031 is needed.

Like-Kind Exchanges

Under Sec. 1031(a), no gain or loss is recognized when property held for use in a trade or business or held for investment is exchanged solely for like-kind property to be held either for use in a trade or business or for investment. Like-kind real property is defined very broadly. For example, vacant land is of like-kind to developed land and buildings, as are residential real estate and nonresidential real estate. (12) Under Sec. 1031(b) and (c), if a transaction is not solely an exchange of like-kind properties, any boot received (i.e., cash, debt relief or the FMV of non-like-kind property received) triggers gain (but not loss) recognition. Also, if boot property (i.e., non-like-kind property) is given in the exchange, gain or loss is recognized on the boot property disposed.

The like-kind property disposed in the exchange is referred to as the relinquished property. The like-kind property acquired in the exchange is referred to as the replacement property. A like-kind exchange may involve deferred or nonsimultaneous exchanges. Such exchanges typically involve multiple parties; usually, one of these parties is a qualified intermediary (QI). The QI helps to ensure the transactions qualify as a like-kind exchange.

Nonrecognition treatment may not apply to exchanges between related persons. Under Sec. 1031(f), if the related party disposes of the relinquished property or the taxpayer disposes of the replacement property within two years after the exchange, the taxpayer generally must include the deferred gain in the year of the subsequent disposition. (13)

The article assumes (1) the property exchanged is like-kind real estate; (2) related parties are not involved in the transactions; (3) if a nonsimultaneous transaction is involved, it is done properly (14); (4) the taxpayer's intent at the time of the transaction is to use the replacement property as trade or business or investment property (15); (5) if the business portion of the property is separate from the dwelling unit, the use test is not met with respect to that portion; and (6) no Sec. 121(f) election out of the exclusion is made.

Sale of a Residence and Like-Kind Exchange

As discussed above, residential property can also be used as business property. Business property is eligible for like-kind exchange treatment, while personal-use property is not. When the relinquished property is mixed-use property, which set of rules--Sec. 121 or 1031--applies? In what order? Sec. 121(d)(10) and Rev. Proc. 2005-14 answer these questions.

Sec. 121(d)(10)

There are important policy reasons for Secs. 121 and 1031. The Sec. 121 exclusion encourages home ownership; Sec. 1031 defers paper gain or loss on an exchange when the replacement property is, essentially, a continuing investment of the same sort as the relinquished property. Congress, however, was concerned that a taxpayer could defer gain in a like-kind exchange of relinquished, appreciated real property for a replacement building (with underlying land), and then, after a suitable time, convert the building and land into his or her principal residence. The taxpayer could then sell the replacement property two years after the conversion and exclude up to $250,000 ($500,000 if married filing jointly) of the previously deferred gain.

Example 3: Taxpayer P owns an eight-unit apartment building ($400,000 basis and $700,000 FMV) in Michigan, but wants to buy a luxury condominium in Florida. Using the services of a QI, P transfers the apartment building and $500,000 on Jan. 1, 2005; on Feb. 18, 2005, he receives the condominium (worth $1.2 million), which he holds for rental purposes. P's $300,000 realized gain ($1,200,000-$900,000) is deferred under Sec. 1031. His basis in the condominium is $900,000 ($1,200,000 value of replacement property--$300,000 postponed gain or, alternatively, $400,000 basis of relinquished property + $500,000 boot given to acquire the Florida condominium). On March 1, 2007, P ceases to rent the condominium and occupies it as his principal residence. On April 13, 2009, he sells it for $1.65 million. Thus, at the time of its sale, the condominium has been owned and used for two out of five years as a principal residence.

For sales of otherwise eligible Sec. 121 property after Oct. 22, 2004, Sec. 121(d)(10) bars the Sec. 121 exclusion if the property sold was acquired in a like-kind exchange within five years of its sale date. (16) Because P did not wait until Feb. 18, 2010 (17) to sell the condominium, none of the gain is excluded under Sec. 121. Also, Sec. 121(d)(10) is effectively retroactive in application, because it refers to sales after Oct. 22, 2004. Consequently, a property acquired by like-kind exchange as early as Oct. 24, 1999 (18) could be affected by this provision.

In Example 3 above, P converted his condominium from rental property to his principal residence more than two years after the acquisition. What if the condominium was only rented for a short period (such as three months, six months or one year after the exchange), then occupied by the taxpayer as his principal residence? Or if P held the condominium only for rental after the exchange, but never actually rented it? Under which of these circumstances (if any) would the replacement property be deemed held by P as personal-use property, rather than as business or investment property, immediately after the exchange, thereby precluding Sec. 1031 treatment?

Neither the Code and regulations, nor the cases, set a "bright line" test of how long rental use must continue before property can be converted to personal-use property. A taxpayer's intent to hold property for business or investment use is determined at the time of the exchange. (19) Consequently, the taxpayer should provide objective evidence of intent to use the replacement property for business or investment. In Example 3 above, P would include Form 1040, Schedule E, with his returns for 2005-2007 to report the condominium's operating results. Perhaps that would also be sufficient to show his intent to use it as rental property at the time of the exchange. Note: Form 8824, Like-Kind Exchanges, would have been filed for 2005. Thus, the IRS would be on notice that the condominium was replacement property for rental property.

Rev. Proc. 2005-14

The purpose of Rev. Proc. 2005-14 is to provide guidance on the application of Secs. 121 and 1031 to a single exchange of property. Thus, the procedure assumes that, at the time of the exchange, all (or at least some portion) of the relinquished property is trade or business or investment-use property. The Code and regulations do not describe how these two provisions interact. However, they do describe how Secs. 121 and 1033 (involuntary conversions) interact. (20) The principles for that interaction have now been extended to the interaction between Secs. 121 and 1031.

Interaction of Secs. 121 and 1033: If a taxpayer's property is involuntarily converted at a gain, the proceeds generally may be reinvested in "similar" property within two years, to postpone all or part of the realized gain. (21) If the involuntarily converted property is the taxpayer's principal residence eligible for Sec. 121 gain exclusion, Sec. 121 is applied first to exclude part or all of the realized gain; the remaining gain realized may be deferred in whole or in part if the taxpayer purchases another residence within the required time period and makes a Sec. 1033 election.

Example 4--Sec. 121/1033 interaction: On Feb. 20, 2005, a fire destroys C's principal residence. Before the fire, the residence had been owned and used at least two of the prior five years as C's principal residence. Her adjusted basis in the home is $345,000 and she receives a $650,000 insurance settlement. Thus, there is $305,000 realized gain from the disposition of the residence, of which $250,000 is excluded under Sec. 121. The remaining $55,000 gain is deferred if C purchases another home (by Dec. 31, 2007) for at least $400,000 ($650,000 insurance proceeds--$250,000 gain excluded under Sec. 121) and makes a Sec. 1033 election. (22)

In Example 4, the Sec. 121 excluded gain "disappears" from the transaction. Specifically, the amount excluded under Sec. 121 reduces the amount realized from the involuntary conversion for Sec. 1033 purposes. A similar approach is used in Rev. Proc. 2005-14 but, because mixed-use property is involved, there is more complexity in the Sec. 121/1031 overlap. For example, potential taxability of gain to the extent of post-May 6, 1997 depreciation and possible gain recognition due to boot received in the exchange also have to be considered. In effect, Rev. Proc. 2005-14 offers several principles that guide the interaction of Secs. 121 and 1031.

Conclusion

Part II, in the December 2005 issue, will discuss and illustrate in detail the interaction of Secs. 121 and 1031 in mixed-use property cases, based on the principles set forth in Rev. Proc. 2005-14.

For more information about this article, contact Prof. Orbach at [e-mail] or Prof. Dilley at [e-mail]

Editor's note: Prof. Orbach is a member of the AICPA Tax Division's Tax Executive Committee.

Kenneth N. Orbach, Ph.D., CPA 

Professor of Accounting

Florida Atlantic University 

Boca Raton, FL

Steve Dilley, Ph.D., J.D., CPA

Professor of Accounting

Michigan State University 

East Lansing, MI

(1) Sec. 121(d)(10) reads: "If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property." A different version of Sec. 121(d)(10) relates to property acquired from a decedent after 2009. Section 2(ee) of the Tax Technical Corrections Act of 2005, H 3376 and S 1447, 109th Cong., 1st Sess. (7/21/05), would renumber the latter provision as 121(d)(11). The technical correction would clarify Sec. 121(d)(10) in two ways. First, Sec. 121 denial would require some gain deferral in the Sec. 1031 exchange. Second, Sec. 121 denial would also apply to a person whose basis in the residence is carried over from the taxpayer who engaged in the Sec. 1031 exchange.

(2) Rev. Proc. 2005-14, IRB 2005-7, 528.

(3) See Sec. 121(a) and (b)(1). For a more complete discussion of the implications of Sec. 121 and its regulations, see Dilley, "Tax Planning for the Sale of a Principal Residence," Part I, 35 The Tax Adviser 30 (January 2004) and Part II, 35 The Tax Adviser 90 (February 2004).

(4) See Sec. 121(b).

(5) For this purpose, a "dwelling unit" includes a house, apartment, condominium, mobile home, boat or similar property, which provides basic living accommodations, such as sleeping space, a toilet and cooking facilities; see Regs. Sec. 1.121-1(e)(2), which cross-references Sec. 280A(f)(1), and Prop. Regs. Sec. 1.280A-1(c).

(6) However, when Sec. 1031 also applies, an allocation of basis and proceeds is needed; see Rev. Proc. 2005-14, note 2 supra, Section 5, Examples 3-6; see also Example 3 in Part II of this article in the December 2005 issue.

(7) See Sec. 121(d)(6) and Regs. Sec. 1.121-1(d). If some of the gain is taxable, the entire transaction is reported on Form 4797, Sales of Business Property (Also Involuntary Conversions and Recapture Amounts Under Sections 179 and 280F(b)(2)), Part III, Gain From Disposition of Property Under Sections 1245, 1250, 1252, 1254, and 1255. The gain is carried to Form 4797, Part I; the excluded portion of the gain is shown as a loss, to reduce the gain to the taxable portion. Taxable gain to the extent of prior depreciation is unrecaptured Sec. 1250 gain, which is generally taxed at a 25% maximum rate if a taxpayer has positive net capital gain for the tax year; see Sec. 1(h)(1) and the instructions to 2004 Form 4797, p. 2.

(8) This is a conversion of business-use property to personal-use property. Of course, no depreciation is allowable after this conversion. As will be discussed in Part II of this article, conversion from personal- to business-use property is also possible. In those circumstances, the property's depreciable basis is the lower of its fair market value (FMV) or adjusted basis at the conversion date.

(9) See Regs. Sec. 1.121-1(d)(2) and (e)(1). If no depreciation was deductible because of the Sec. 280A(c)(5) limit on home office deductions, then none of the gain in Example 1 is taxable.

(10) The property is a Sec. 1231 asset, because it was either rented or used in the taxpayer's business. The portion of the sale allocable to the Sec. 1231 asset is reported on Form 4797. The portion allocable to the personal-use residence is not reported on the return if all the personal-use gain is excluded under Sec. 121.

(11) See Regs. Sec. 1.121-1(d)(1) and (e)(1).

(12) See, e.g., Regs. Sec. 1.1031(a)-l(b) and Kate J. Crichton, 122 F2d 181 (5th Cir. 1941). Sec. 1031(h)(1) provides, however, that real property located in the U.S. is not of like-kind to real property located in another country.

(13) Although Sec. 1031(f) also applies to a deferred loss, the taxpayer generally would not be able to deduct such loss; see Sec. 267(a)(1).

(14) See Regs. Sec. 1.1031(k)-1 (deferred exchange); and Rev. Proc. 2000-37, 2000-2 CB 308, modified by Rev. Proc. 2004-51, IRB 2004-33, 294 (reverse deferred exchange).

(15) If the taxpayer's intent at the time of the transaction is not to use the replacement property in a trade or business or for investment, then the transaction is not a qualifying like-kind exchange. Thus, a rental building exchanged for a building that the taxpayer intends to use as his or her personal residence does not qualify as a like-kind exchange; compare Dollie Click, 78 TC 225 (1982), with Fred S. Wagensen, 74 TC 653 (1980).

(16) Example 3 would be unchanged by the Tax Technical Corrections Act of 2005, note 1 supra, because P deferred gain in the Sec. 1031 exchange.

(17) The Sec. 121(d)(10) five-year period begins with the property acquisition date in a Sec. 1031 transaction (here, Feb. 18, 2005). Thus, the five-year period ends on Feb. 17, 2010, making Feb. 18, 2010 the first day to sell the condominium without triggering Sec. 121(d)(10).

(18) The Sec. 121(d)(10) five-year period begins with the property's acquisition date in a Sec. 1031 transaction. Thus, for property acquired on Oct. 24, 1999, the last day of the "bad" five-year period was Oct. 23, 2004, the first day that Sec. 121(d)(10) applied.

(19) See Click, note 15 supra.

(20) See Sec. 121(d)(5) and Regs. Sec. 1.121-4(d).

(21) See Sec. 1033(a)(2)(A) and (B)(i).

(22) See Regs. Sec. 1.121-4(d)(4) for a similar example.