combining section 121 gain and 1031 exchange

[Tatyana Shevnina]

When combining section 121 gain and 1031 exchange, can you take out the section 121 gain or does it have to be included in the cost of the replacement property?

For example, relinquished property is sold for $800K with $600K capital gain, where $500K qualifies for 121 exclusion and $100K is deferred via 1031 exchange. Can you take out $500K tax free and buy a replacement property for $300K? Or do you still need to reinvest the full $800K into the replacement property? I omitted closing costs, etc. for simplicity. 

In prior threads, @Dave Foster (can't tag for some reason) mentioned that section 121 gain is boot, but ultimately becomes tax free once 121 exclusion is applied. From that I gathered that $500K can be taken out tax free. Wanted to double check that my understanding is correct.

Thanks in advance!

[Dave Foster]

@Kenneth Reimer and @Tatyana Shevnina,  Thanks for connecting with me Tatyana.  Now I'm here :)

That is correct - sec 121 is available only for your primary residence that you have lived in for 2 out the previous 5 years.  Sec 1031 is only available for investment property.  HOWEVER - What happens with the property that you are now using for a rental (1031 qualifying investment property) that you have also lived in for 2 out of the last 5 years (qualifying sec 121 property)?  A property in this situation meets both sets of qualifications.  If the gain is less than the $500K ($250K if single) then you would just want to apply sec 121 and take the gain tax free.  But that still leaves depreciation recapture which could be significant.  Even more so if the gain exceeds the limits of sec 121.

The answer is to actually combine the two statutes.  You begin a 1031 exchange but take $500K in cash boot.  Normally this boot would be taxable in a 1031 exchange.  But since you have lived in it for 2 out of the previous 5 years you get that tax free under sec 121.  

It's an incredibly elegant solution.  And many folks living in houses that would exceed the sec 121 limits decide to retain ownership of their home for a period of time and put it into service so they can then sell and take advantage of sec 121 for tax free cash and defer the rest through 1031.