TAX BREAK

Like-Kind Exchange Treatment for Both Personal and Business Use Property by Douglas E. McCash

 

Internal Revenue Code (“IRC”) § 121 permits taxpayers to exclude up to $250,000 gain (or $500,000 for a married couple filing a joint return) realized on the sale or exchange of property that was used as the taxpayer’s principal residence for at least 2 years during the 5-year period ending on the date of the sale or exchange.  IRC § 1031 permits taxpayers to defer gain on the sale of property held for productive trade or use in a business or for investment purposes, by reinvesting in other “like-kind” business property. 

 

Many times, a taxpayer will wonder how long business property must be used for investment purposes before converting it to personal use without running afoul of the IRS.  Prior to the passage of the American Jobs Creation Act in October of 2004, little guidance had been given with respect to this issue.  As a result, aggressive taxpayers could take advantage of this perceived loophole by deferring gain on business property as part of a § 1031 exchange and then also benefiting from the exclusion of gain under § 121 by quickly converting the property to their personal residence after completing their exchange. 

 

In the past, there had been no hard and fast rule on how long a taxpayer had to hold property acquired in a § 1031 exchange before being allowed to convert it to personal use.  With the passage of the American Jobs Creation Act, property acquired in a § 1031 like-kind exchange will no longer be eligible for § 121 exclusion of gain if the property is sold during the 5-year period beginning with the date of the acquisition of the property. 

 

Further guidance was issued on the interplay of §§ 121 and 1031 with the issuance of Revenue Procedure 2005-14.  In certain cases, a homeowner may benefit from both the home-sale exclusion from income and a like-kind exchange deferral of gain.  Rev. Proc. 2005-14, which became effective January 27, 2005, specifically applies to taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the sale of a principal residence under § 121 and the non-recognition of gain on the exchange of like-kind properties under § 1031.  In such cases, the property would have been used consecutively or simultaneously as a home and a business.

 

To compute gain from transactions where both §§ 121 and 1031 apply, taxpayers must first apply § 121 to the gain realized before applying § 1031.  Rev. Proc. 2005-14 further specifies that boot (cash or other non-like-kind property received by the taxpayer in the sale of relinquished property) is taken into account only to the extent that the boot exceeds the gain excluded under § 121.  Basis in the replacement property is computed by adding any gain attributable to the relinquished business property that is excluded under § 121. 

 

Various examples of how these rules can be applied are included in Rev. Proc. 2005-14.  One such example involves the consecutive use of a property as a home and then as a rental property.  Janet buys a house for $210,000, and uses it as a primary residence for four years.  For the next two years, she rents out the house and claims depreciation in the amount of $20,000.  Janet then exchanges the house for $10,000 cash and a townhouse with a fair market value of $460,000, which she plans to rent to tenants.

 

 

 

Continued

 

 

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