Converting from a 1031 to a Section 121

[Leah Dockter]

If a partnership does a 1031 exchange into 2 rental homes and then decides to distribute them to the partners can the partners qualify for a 121 each?  This is assuming each partner lives in a house for 2 of the 5 years.  When does the 5 years begin?  When the 1031 exchange was done or when it was distributed to qualify for the 121?

[Dave Foster]

@Leah Dockter, Several questions there.

1. Can a partnership entity dissolve and distribute properties to the partners that were formerly 1031d into by the partnership entity - Yes. In general contributions into and distributions out of an entity do not create a taxable event.  Make sure your accountant is quarterbacking it so there's not an inadvertent recognition of gain.

2. Can the partners move into the properties once they have been distributed - Yes.  The way in which they use them is up to them.

3. Can the partners get the full 121 benefit after living in the properties for 2 out of the 5 years prior to sale - No (but a qualified no).  You can read my story of how I did exactly this combination of 1031 to 121 and ended up with the sailboat of my dreams raising my family on the sea for a decade at www.the1031investor.com .  But that was prior to 2008.

Since 2008 the full 121 exemption is no longer available.  But it can still be very beneficial.  Your question is very interesting because it is the partnership that did the 1031 exchange.  The partners may not be required to adhere to the IRS requirements for conversion of an investment property since they were simply given the properties in exchange for membership interest in the dissolved company.  I'll let our esteemed CPAs battle that one around.

Conversions when done by individuals since 2008 have some different rules that you would want to be aware of if they apply to dissolved partnership property.

1. When the property converted to primary residence was once a part of a 1031 exchange the owner has to have owned it for a minimum of 5 years.

2. the owner still has to have lived in it for at least 2 out of the 5 years prior to sale.

3. The owner now only gets to prorate the tax free gain between periods of qualified use (actually lived in as primary) and non-qualified use (periods of investment use).  So if they converted it and rented it for 2 years and then lived in it for 3 they could exempt 3/5ths of the gain tax free.

4. All depreciation must still be recaptured.

But I'm still intrigued to hear some CPA responses to this because I think that the above 4 items might not be factors because the investment use and depreciation were all taken by and part of the ownership by the now defunct partnership entity.  The new owners are not really converting a property.  They are simply using a property that they own in a certain way (if they moved into it immediately).  

Love the question.  And really loved taking advantage of the pre 2008 rules.