Combining IRS 121 and §031 for permanent tax exclusion

1031 Exchanges are also called tax-deferred exchanges which means the tax basis from the sales property is not eliminated but carried over to the property that is purchased. While the tax deferral benefits of exchanging are only allowed on investment property, Section §121 of the code has a permanent tax deduction that can be taken on the sale of a primary residence. As long as the taxpayer has lived in the property for a total of two years out of the previous five, they can claim a $250,000 deduction ($500,000 for joint filers) from their income tax. With planning, these two tax strategies can be combined to exclude the capital gains from the sale of investment property.

If an exchanger acquires a property, rents it for a number of years, moves into the property as a primary residence for at least 2 years, it is possible to then sell that residence and exclude up to $250,000 of gain ($500,000 if filing jointly) from their taxes.

In late 2004, Section §121 was revised to add a five-year holding period before a taxpayer can exclude gain under Section §121 when selling a primary residence that was acquired initially as investment property in a §1031 Exchange. For example: if the property acquired in the §1031 Exchange is rented for three years, then used as a primary residence for two years, the taxpayer will be able to sell it and exclude up to $250,000 of the gain pursuant to Section §121. The residence was owned for a minimum of 5 years and used as a primary residence for 2 out of the last 5, meeting all the requirements of the updated tax law. Thus, with careful planning, the tax deferral of §1031 Exchanges can be converted to permanent tax exclusion by combining these two tax strategies.