The IRS recently issued Rev Proc 2005-14, 2005-7 IRB. This Revenue Procedure clarifies that the exclusion of gain from the sale of a principal residence under IRC § 121 may be combined with a like-kind exchange under IRC § 1031. This Revenue Procedure also provides six examples of how these two provisions of the Internal Revenue Code work together.

Background

Under IRC § 121, a taxpayer may exclude from gross income up to $250,000 ($500,000 for joint filers) of gain from the sale or exchange of the taxpayer's principal residence. To qualify for this exclusion, the property must have been owned by the taxpayer and used as his or her principal residence for two of the preceding five years, but need not be the taxpayer's principal residence at the time of the sale or exchange.

For purposes of IRC § 121, property used partially as a principal residence and partially for a business purpose still qualifies (in its entirety) as the taxpayer's principal residence, so long as it is one "dwelling unit." Treas Reg § 1.121-1(e). However, gain may not be excluded under IRC § 121 to the extent that such gain is attributable to depreciation deductions taken after May 6, 1997.

Under IRC § 1031, no gain is recognized on the exchange of property held for investment or for productive use in a trade or business if the property is exchanged for property of "like-kind" to be held for investment or for productive use in a trade or business. Gain is recognized, however, to the extent that the taxpayer receives cash or other property not of like kind ("boot") in the exchange.

Why apply both IRC § 1031 and IRC § 121 to the same transaction?

Given that IRC § 121 is an exclusion of gain (the gain is never taxed) and IRC § 1031 is a deferral of gain (the gain is deferred until the replacement property is ultimately sold), why would a taxpayer ever want to treat the qualifying sale of a principal residence, even partially, as an exchange under IRC § 1031? The answer: in situations where the taxpayer has gain that cannot be excluded under IRC § 121. These situations occur when (i) the principal residence and business-use property are separate "dwelling units"; (ii) gain is attributable to depreciation adjustments claimed after May 6, 1997; or (iii) the amount of gain exceeds the amount excludable under IRC § 121.

Application of Rev Proc 2005-14

Rev Proc 2005-14 applies only to transactions in which the taxpayer exchanges property that satisfies both the requirements for exclusion under IRC § 121 and for like-kind exchange treatment under IRC § 1031. Thus, the property must be, or have been for two of the previous five years, used as the taxpayer's principal residence, and the property must be, at the time of the exchange, held, at least in part, for investment or for productive use in a trade or business.

This can occur when the property is used sequentially or concurrently as a principal residence and as investment property or for productive use in a trade or business. For instance, a principal residence that has been converted to a rental property would fall under the Revenue Procedure, as would a home used partially as a principal residence and partially as a home office.

How does Rev Proc 2005-14 work?

Rev Proc 2005-14 applies essentially the same analysis to a combined IRC § 121 exclusion and IRC § 1031 exchange as is applied by statute (IRC § 121(d)(5)(B)) to a combined IRC § 121 exclusion and IRC § 1033 gain deferral from an involuntary conversion.

The Revenue Procedure explains how to compute gain and how to compute the new basis (in the replacement property) when IRC § 121 and IRC § 1031 are applied simultaneously. Where the property, at the time of the exchange, is simultaneously used as a principal residence and for a business purpose, it is necessary to compute the gain separately for each portion of the property. As mentioned above, IRC § 121 may apply to both portions of the property if there is a single dwelling unit. However, IRC § 1031 may be applied only to the portion of the property used for a business purpose.

Computing Gain. Gain is computed by applying three rules:

  1. IRC § 121 is applied to exclude realized gain before applying IRC § 1031;
  2. IRC § 1031 is applied to defer gain attributable to depreciation deductions after May 6, 1997; and
  3. In applying IRC § 1031, boot (cash or non-like-kind property) received in the exchange is taken into account (and taxable) only to the extent that it exceeds the gain excluded under IRC § 121.

Computing Basis. In computing the basis of the investment or business-use property acquired in the exchange, the amount of any gain excluded under IRC § 121 with respect to the relinquished business-use portion of the property is added to the basis of the replacement business property.

The Revenue Procedure is effective January 27, 2005, but may be applied by a taxpayer to any tax year that is open for refund or credit.

Examples

The Revenue Procedure includes six examples showing how its rules apply in various situations. These examples break down into three basic scenarios:

Example 1: Sequential Use. Taxpayer exchanges a single property that he or she used as a principal residence for two of the five years prior to the exchange, but was then converted to a rental property and held for investment.

In this example, all realized gain, except gain attributable to depreciation adjustments claimed after May 6, 1997, may be excluded under IRC § 121 up to the $250,000 limit. IRC § 1031 may be used to defer any gain in excess of the dollar limitations or attributable to depreciation adjustments. Any boot does not trigger recognition of gain unless it exceeds the total amount gain excluded under IRC § 121.

Example 2: Concurrent Use—Two Units. Taxpayer exchanges property consisting of two separate dwelling units, a house and a guesthouse. The house was used (for at least the two prior years) by the taxpayer as a principal residence, and the guesthouse was held for use in a trade or business.

The Revenue Procedure essentially treats the two portions of the property as separate properties, and no portion of the IRC § 121 exclusion may be used against the business-use portion of the property. Further, IRC § 1031 may not be used to defer any gain associated with the principal-residence portion of the property.

Example 3: Concurrent Use—One Unit. Taxpayer exchanges a single property consisting of one dwelling unit that is used partially as a principal residence and partially in a trade or business.

In this example, Taxpayer may use IRC § 121 to exclude gain on both portions of the property. Taxpayer may use IRC § 1031 to defer gain on the business-use portion of the property that would otherwise be recognized because it exceeded the $250,000 exclusion limit or because it is attributable to depreciation adjustments claimed after May 6, 1997. Boot would not cause gain recognition unless it exceeded the amount of gain excluded by IRC § 121.

The following chart shows the application of Rev Proc 2005-14 in each of the three examples above, assuming that the taxpayer exchanged property having an adjusted basis of $180,000 (including $30,000 of depreciation adjustments claimed after May 6, 1997) and a fair market value of $470,000 for $60,000 cash and properties with a fair market value of $410,000.
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