Broker Check

Complications of Applying the IRS's Rule 121 Exclusion

Howard Hook, CFP®, CPA, quoted in The Star-Ledger's business/finance column, "Biz Brain" on July 1, 2012

Question:  In 2000 we built a vacation rental property for $980,000. In 2005 we sold it for $2.5 million. We used that money to buy another rental property for $2.6 million through a 1031 real estate exchange to defer the capital gains. Now we have retired and are hoping to turn this property into our primary residence. How long do we have to live in this house before we can sell it and take our one-time deduction of $500,000? We have a $900,000 mortgage which we are planning to pay down by $500,000 when we sell the home that we now live in. We will realize a loss of about $100,000 on our home so there will not be any gain there. – Movers and shakers

Answer:  This is complicated stuff. Typically, a 1031 exchange results in the deferral of tax being paid on the sale of property where “like-kind” property is acquired with the proceeds from the sale. Tax is deferred on the sale until the property that was acquired with the proceeds – referred to as the replacement property – is sold,” said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton. “Investment property and rental property are two common types of property where 1031 exchanges are executed,” he said. “1031 exchanges cannot be done with primary residences.”

Hook offers this example: Taxpayer A exchanges a rental property in New York City worth $1 million with a basis of $500,000 for a rental property in New Jersey worth $1 million. The $500,000 gain is deferred until the taxpayer sells the New Jersey rental property. So, if four years later, the New Jersey rental property is sold for $1.5 million, the taxpayer will pay capital gains tax on $1 million ($500,000 deferred gain on 1031 exchange and $500,000 on sale of the New Jersey rental property).

In the above example, what if the taxpayer moved into the New Jersey rental property prior to selling it? It used to be that with the sale of a primary residence, if the taxpayers lived in the home for two of the five years preceding the sale, they could exclude $500,000 ($250,000 for single taxpayer) of the gain. In the above example, the taxpayers would pay tax on $500,000 and not $1 million.

But legislators saw the Treasury was missing out on some good tax revenue, so a change was made.

“The IRS adopted a law after 2008 to avoid taxpayers renting a property and then moving in for two years and taking the $500,000 exclusion,” said Gail Rosen, a Martinsville-based certified public accountant. Now, the 121 exclusion is available, but the maximum excludable amount of $500,000 will be reduced by the period of nonqualified use — any period after 2008 that the property was not a primary residence, she said.

“In English, you have to come up with a fraction and the numerator is the days of non-qualified use — the days after 2008 it was not used as principal residence — and the denominator is the total period you owned the property,” she said. This fraction is multiplied by the maximum excludable amount of $500,000.

Given all that — get yourself a good accountant before you make any moves.