Qualifications needed for doing 1031 + 121 exclusion?

Question

If the house that I currently live in was never rented out before (for many years now), how long do I have to rent it out to someone else in order to qualify for a 1031 exchange and the 121 exclusion together when it’s sold?

Dave Foster · Answer

@Frank Chin, it's really not as uncommon as one would think.  Precisely because of the scenario you described of yourself - the classic MF house hack.  Live in one unit and rent the other.When you sell it's both your primary residence and an investment property.  Really an awesome strategy.

What's not as common but still happens is the situation where the $500K in gain would be exceeded.  So the owner moves out for a couple years.  And then the one property still qualifies for both 121 and 1031.

Sounds like you'll be in that exact position.  50-50 would be better for you wouldn't it!!  It's kind of a bummer when we get old enough that we  outlive our MD and CPA . (not sure which is worse)!  I'm wishing  my own "Turbo" Andy  many more long years of health after 30 sometimes wonderful years of cpa togetherness (although it's my return that may put him in the ground :) .

Frank Chin · Answer

Thanks Dave, I haven't ran across this situation, now you mentioned it, could be utilized for many duplexes and triplexes where the owners lived in one of the units. I myself lived in a duplex where I occupied one unit, and rent out a unit. Currently, expense wise, it's split 50/50 owner/tenant. Bought it way back at auction in 1993 for $200K, and currently $1.3MM, so if I sell now, there's at least a $1MM gain.

I have no current plans to sell. But in anticipation that I do so in the future, looks like I can 1031 the rental portion. Right?? The only issue that gives my CPA headaches is it originally had three units, one was declared illegal, converted to an office which I use, and originally depreciated 1/3 for the rental. Looks like it's 2/3 owner use now.  But expense wise today, I now split the expenses 50/50 on the schedule E for real estate taxes, water bills etc. In the current situation, looks like 50/50 is the correct allocation.

What bothers the CPA is I changed allocations a few years back from 1/3 owner, to 1/2 owner, but not the depreciation. Since I bought it in 1993, it should be fully depreciated soon with 27.5 years depreciation, so I don't want to touch it.  So the issue for him is, at the time of sale, if and when I sell, is it 1/3 owner or 1/2 owner.

I wondered if it will cause issues at the time of sale, when it comes. I had a similar situation once with a triplex, lived in one and rented out two. But then I used one rental unit for 2 years in between myself, as an office, and moved out, rented out the whole building. My CPA kept it simple by having 1/3 owner, 2/3 rental for the whole time I was there, and for capital gains purposes when I sold. Tried to do 1031 but ran out of time.

If my CPA is still around, my guess is he'll say just do the split 50/50, the IRS is not going to go back 30 years and see how you depreciated and split expenses, so 50% owner occupied it is. It's split 50/50 for a number of years now.

Looks like you ran into some of these oddball cases from following your posts and have probably insight. Then again, maybe it's not so oddball.

Ashish Acharya · Answer

If your gain is less than 500k and you are married, you don’t need 1031.

If it was more, you can do 1031 and 121 together.

1031 just defers the gain, so 121 is better.

If you want to get maximum gain exclusion, it is better to wait until house accpreciates more for next three years and sell it, assuming market moves up. That way you dont have to do 1031 and  all you gain is tax free  up to 500k( except dep recapture). If more than 500k, you can attach 1031 defer gain above 500k.

Dave Foster · Answer

@Frank Chin it actually would be possible for @Kevin L. to combine sec 1031 and sec 121 on the same sale - providing he qualified for both.  The scenario works great where there is gain greater than the $500K maximum.  The owner moves out like Kevin is contemplating and puts a rentor in the house for a year or two (there is no statutory period Kevin but a year or two is generally considered OK).  As long as he then sells that house within the next three years after moving out he can take advantage of both.  He is selling an investment property so it qualifies for 1031.  And he has lived in it for two out of the 5 years prior to sale.  So he qualifies for the 121 primary residence exemption.

The mechanism is that the property is sold and a 1031 is started but on the settlement statement for the sale the client takes $500K boot.  This would normally be taxable but the accountant reconciles it with the 121 exemption and voila - no tax on that.  Meanwhile the client completes a 1031 with the rest of the proceeds.

We're actually doing one of these right now where the gain is less than $500K but the client wants to defer significant depreciation recapture.  Since he qualifies for both he will be taking the gain tax free under sec 121 but will be deferring depreciation recapture under 1031.

But like @Ashish Acharya, said, if the gain is less than $500K and he doesn't have depreciation to recapture then he doesn't need a1031 at all.

Frank Chin · Answer

Generally speaking, you are entitled to exclude up to $500,000 for a joint return if the house is your principle residence in 2 out of the last five years. So for most people, for all intents and purposes, you can sell it tax free if you lived in it for a short period of 2 or so years.

If you sell it less than 3 years from now, you're still fall within the 2 out of 5, so you won't need a 1031. But as far as I know, you can't do a 1031 and the 121 exclusion together on the same property at the same time as you mentioned. At least I couldn't think of a situation where this would apply.

There are other technicalities, see article: 121 Exclusion rules The article goes into other special situations.

Qualifications needed for doing 1031 + 121 exclusion?

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