SECTION 121 + 1031
Section 121 is the best of all IRS Tax Code sections for the regular taxpayer, Section 1031 the best for the real estate investor.
Together, Section 121 and Section 1031 can be used to completely eliminate Capital Gains taxes in many situations, and can be used to defer those taxes indefinitely in other situations.
If you need to review Capital Gains and Depreciation Recapture, go to Capital Gains Tax.
The rules for doing an Exchange are at 1031 Exchange Rules.
There are four scenarios where Section 121 and Section 1031 can come together to benefit the real estate investor.
SECTION 121 + 1031 MIXED USE
Sometimes your investment real estate will not be entirely investment real estate. It might have a residence involved, and the residence might be your “primary residence” as that term is used in Section 121.
This is called “Mixed Use” as that term is used by the IRS.
An Example would be a 100-acre farm.
It might contain 95 acres of farm land, and then the house and 5 acres.
The farm is the business that comes under Section 1031, and the house is the personal residence that comes under Section 121.
Another Example would be a motel.
A motel might contain the office, lounge, laundry, and rental units, and then contain a separate living unit which is the owner’s residence.
The residence doesn’t even have to be physically separate, as long as it can be dealt with separately as far as the numbers are concerned.
If you are involved in a situation like this, you will want to allocate as much of the property value as possible to the personal residence category and take advantage of the Section 121 exemption, because all of that Capital Gains could be completely tax-free.
Then you can do a Section 1031 Exchange with the remainder of the property, and defer the taxes on the Capital Gains and the Depreciation Recapture by purchasing a like kind investment property.
If you come across a word or term that you don’t understand, visit our Dictionary.
SECTION 121 RESIDENCE TO RENTAL
The best of the four combinations of Section 121 and Section 1031 is where you purchase a house as your primary residence and live in it for two years, qualifying for the Capital Gains tax exemption of up to $500,000 for a married taxpayer and $250,000 for a single taxpayer available under Section 121.
It's Like A Seminar In A Book
Remember, the qualification says that you owned the property and lived in it as your primary residence for two years out of the five years prior to the sale.
That is the key to this strategy.
It means that you don’t have to sell the property when you move out in order to use Section 121.
You can now use it as a rental property for three years, and still claim the exemption from Capital Gains taxes for the entire five-year period.
This exclusion from Capital Gains taxes includes the Capital Gains that accrued during the three-year period that you were using the property as rental investment property, and while it was increasing in value.
If you sell the property just prior to the expiration of the five-year period, you can claim the Section 121 Primary Residence exclusion on all of the Capital Gains, not just the amount that accrued while you were living in it.
Your only tax liability will be a 25% tax called a Depreciation Recapture tax, figured on the amount of depreciation that you claimed during the three years that the property was a rental investment property.
Let’s use an Example.
Assume that you purchased a $350,000 residence, lived in it for two years, rented it out for three years, and sold it for $514,265 just prior to the expiration of the five-year period. This assumes an annual 8% increase in value.
What are your numbers?
Your Capital Gains after two years is $58,250 and this would be exempt from taxation if you sold at that point. But you rented it for three years.
You claimed $38,182 in depreciation during the three years of rental.
So, your Capital Gains after five years is $164,250 of true Capital Gains, and $38,182 of Capital Gains attributable to the reduction in Basis caused by the depreciation.
The $164,250 of true Capital Gains would all be exempt from taxation under Section 121.
Your Depreciation Recapture tax of 25% on the $38,182 would $9,545, and this would be your only tax.
Your Section 121 exemption would eliminate $32,850 of Capital Gains tax.
And there is even a way that you can sell the property to yourself, and continue with your current tenant and cash flow, while taking out all of your profit.
I cover that technique elsewhere on the site.
RENTAL TO SECTION 121 RESIDENCE
You don’t have to go out and buy a primary residence in order to use Section 121 and Section 1031 together to exempt or defer taxes.
Assume the same circumstances as above, except that when you bought the $350,000 property you immediately began using it as a rental real estate investment, and continued for almost three years.
Then, you moved into it, and used it as your primary residence for two years.
If you now sell the property for $517,000, what are your numbers?
The math is a bit different from the previous Example.
Your true Capital Gains, the difference between what you paid for the property and what you sold it for, is $167,000.
The IRS assumes, and requires you to do the same, that the amount of Capital Gains accruing was the same for each year.
$167,000 divided by five years is $33,400 per year.
You owned and lived in the property as your primary residence for two of the five years, so you can exempt two-fifths, or 40% of the Capital Gains, a total of $66,800.
The remaining $100,200 of Capital Gains is taxable at your personal rate, which we are assuming to be a total of 26% federal and state.
Also taxable is the $38,182 of Depreciation Recapture at 25%.
You would pay $26,052 tax on the $100,200 of Capital Gains.
You would pay $9,545 tax on the Depreciation Recapture.
Your total taxes would be $35,597.
This assumes that you don’t do a Section 1031 Exchange to defer these taxes.
This compares to paying $9,545 for doing the same thing, only in reverse order.
Planning is what will make you much more successful.
In order to do this, you must make sure that when you bought the property, you bought it either in your name, or in the name of a Limited Liability Company (LLC) which is treated as a disregarded entity for tax purposes.
This satisfies the Section 121 requirement that you actually owned the property during the two years that you were living in it for Section 121 qualification.
SECTION 1031 TO SECTION 121
Assume the same scenario as above, but with one critical difference.
When you acquired the property, you did so in a Section 1031 Exchange, and the property was your Replacement Property.
In 2004, the IRS added the requirement for this scenario that you must own the property for at least five years, along with all of the other qualifications, in order to use Section 121.
So, everything would be the same as the above scenario, except that you would probably use the property as investment rental property for more than three years, so that when you moved in and used it as your primary residence for two years, your total ownership would be more than a total of five years.
However, I cannot tell you what your numbers would be under this scenario.
Depreciation, Basis, Capital Gains, Section 121 exclusion amount, Depreciation Recapture amount, etc., would all depend on the carryover amounts from the Relinquished Property when you purchased this property as your Replacement Property.
It’s complicated. But it can be done.
SECTION 121 CONCLUSION
There is actually another scenario where Section 121 and Section 1031 come together to benefit the real estate investor.
That situation is where you purchase a Duplex or a Fourplex and live in one of the units while renting out the others.
But it is a discussion that requires more space than we have here.
I urge you to learn about Section 121 and how to use it in conjunction with Section 1031. If you are a real estate investor, this is where you can make the most money with the least amount of effort.
Planning doesn’t cost anything. It just takes time, and an appreciation of its value.
A smart investor can actually hold investment property for three years, sell it, keep the money, and pay no Capital Gains tax. This is the only way that you can do that.