Minimizing taxes implications on primary residence: 121 plus 1031

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Minimizing taxes implications on primary residence: 121 plus 1031

Curt WortmanPro Member
Rental Property Investor · Raleigh, NC · Member since 2020 · 10 posts · 8 votes

I'm considering selling my primary residence and moving out of state... yes I'm from the amazing overpriced California. Before making any decision I'm researching what are my options for minimize the tax implications. I will be purchasing a property on the East Coast at a fair less amount taking any remainder gains and purchase rental income properties.

Background: I have lived in my home for 10 years watching the prices of house steadily climb. From my research on 121 capital gains exclusion, this would allow for $500K tax free since I'm married. The challenge is to minimize the tax penalty on the remainder of capital gains. From a simplistic calculation the remaining taxable income = Purchase Price - Sale Price - $500K from 121. The rental income of this California would be ~$4k/month which only covers existing mortgage and property taxes, therefore much better ROI for cash flow elsewhere assuming that appreciation would remain flat for the next few years.

My limited understanding:

1. If you live in the residence for 2 of 5 years, then I can apply for the 121 benefit. Check!

2. 1031 exchange could be used within the 3 year remaining. Proper handling of identification and conversion per the 1031 stated timeline would be required.

Do I need convert the property to a rental to take advantage of 1031 exchange? If so, then how long do I need to wait selling this newly converted rental property?

I would like to hear from the experts if they have any creative solutions to minimize taxes. I will be using a CPA in conjunction but there is a broad spectrum of knowledge in the forums that might result in some better options...

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
6y

@Curt Wortman, You can take advantage of whatever part of the code you qualify for.  

1. For. your primary residence if you have lived in the property and owned it for 2 out of the 5 years prior to sale you get the 121 exemption.

2. If the property is being used for investment when you sell it you can do a 1031.

3. So it is possible to move out of your primary, use it for rental for up to 3 years, sell and take both the 121 and 1031 options.  In this example you will have to recapture depreciation during the time it was an investment property.

4. If your gain is more than $500K this is a great way to mitigate that.  Convert into a rental for a year or so and then sell and start a 1031.  Take $500K of boot (normally taxable but not this time because of 121).  Do a 1031 on the remaining and defer all the rest.

The one thing this doesn't help with would be your new primary.  You cannot do a 1031 into your primary residence unless you use it for investment first for a while.  But... This about this scenario - Move out of your house for a year.  Then sell and do the combo 1031/121.  Don't buy your new property initially.  Instead rent for two years or so (the year before you sell your old property and the year after the 1031 is complete).  Use the 1031 to buy a really nice investment property and use it for investment while you are renting where you are.  After your lease is up you decide to convert the property from investment to your new primary residence.  Everything tax free or tax deferred and you get a new primary out of the deal.

Yes, it works!!

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  • Katie L.
    Attorney and CPA · San Diego, CA · Member since 2017 · 590 posts · 422 votes
    6y

    @Curt Wortman

    Check with your own CPA but it is likely that you can use only one of the 121 exclusion or the 1031 tax free exchange.  Yes, would need to be an "investment" property before can use the 1031 tax-free exchange.

    *This post does not create an attorney-client or CPA-client relationship.  Readers are advised to seek professional advice.  The information contained in this post is not to be relied upon.

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    6y

    @Curt Wortman, You can take advantage of whatever part of the code you qualify for.  

    1. For. your primary residence if you have lived in the property and owned it for 2 out of the 5 years prior to sale you get the 121 exemption.

    2. If the property is being used for investment when you sell it you can do a 1031.

    3. So it is possible to move out of your primary, use it for rental for up to 3 years, sell and take both the 121 and 1031 options.  In this example you will have to recapture depreciation during the time it was an investment property.

    4. If your gain is more than $500K this is a great way to mitigate that.  Convert into a rental for a year or so and then sell and start a 1031.  Take $500K of boot (normally taxable but not this time because of 121).  Do a 1031 on the remaining and defer all the rest.

    The one thing this doesn't help with would be your new primary.  You cannot do a 1031 into your primary residence unless you use it for investment first for a while.  But... This about this scenario - Move out of your house for a year.  Then sell and do the combo 1031/121.  Don't buy your new property initially.  Instead rent for two years or so (the year before you sell your old property and the year after the 1031 is complete).  Use the 1031 to buy a really nice investment property and use it for investment while you are renting where you are.  After your lease is up you decide to convert the property from investment to your new primary residence.  Everything tax free or tax deferred and you get a new primary out of the deal.

    Yes, it works!!

    The 1031 Investor5137 Reviews
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  • Curt WortmanPro Member
    OP
    Rental Property Investor · Raleigh, NC · Member since 2020 · 10 posts · 8 votes
    6y

    Thanks @Dave Foster and @Katie L..

    My understanding is that I will need to covert my primary into a rental property then hold for minimum of 2 years before IRS considers it a qualified 1031 exchange. This pushes me to most likely 2023 before selling with is a long wait given the economy. I looking at $900K capital gains minus the $500K from 121. 

    Bonus depreciation on cost segregation for a rental property investment my be a way to offset the capital gains if the transaction occurs in the same year? I'm not sure about carry forward and back capital gains/losses. Plus I'm getting a feeling that bonus depreciation might be on the chopping block at least on old construction for 2021 tax season. Government will need to review what existing program needs to be cut for funding their huge debt interest payments.

    Seller financing would hold the payments even further delaying and immediate cash into rental investments.

    Not sure if the above information is correct based upon my limited knowledge and whether there are other strategies to be considered.

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  • Bill ExeterBusiness Member
    1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
    6y

    Hi @Curt Wortman, 

    Yes, you would qualify for both.  

    You satisfy the 2 out of the last 5 year requirement for the 121 Exclusion, so you would qualify for the $500,000 tax free exclusion.  

    You can also move out of your home, convert it to a rental property, hold as a rental property long enough to demonstrate intent to hold as rental, and then sell before the end of the 3 year window of opportunity and qualify for a 1031 Exchange.  

    It is the best of both worlds.  You can still say that you have lived in the home for 2 out of the last 5 years and the property was held as an investment property for the last couple of years, so you would qualify for both the 121 Exclusion and the 1031 Exchange.  The applicable IRS Revenue Procedure is 2005-14 that addresses this topic/issue. 

    The minute you move out of the home you start a three (3) year window of opportunity, so you must make sure that you sell and close on the sale of the property before the end of the 3 year window. 

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    6y

    @Curt Wortman, Your question is about qualified  use after you convert your property from your primary residence to investment.  There is no statutory holding period that qualifies it as investment.  The standard is your intent which you can demonstrate a number of ways.  Of course actually renting the property out is a very good demonstration of that intent.  the 2 year period is not statutory at all other than a safe harbor under certain circumstances.  Most folks feel comfortable at anything more than a year.  There can always be situations where a hold of less than (or more than that) might be appropriate.

    Of course you'll the full 3 year period after you move out to complete your sale as an investment property and during that time you'll get all the benefits of depreciation, cash flow, and amortization of the loan by the tenant.  Just be very careful when closing that sale that you can look back the 5 year period prior and document that you resided there if you want the 121 tax free exclusion.  Otherwise you lose that but can still 1031 the entire gain and defer tax.

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  • Curt WortmanPro Member
    OP
    Rental Property Investor · Raleigh, NC · Member since 2020 · 10 posts · 8 votes
    5y

    Thanks everyone for the replies and input. 

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