Converting a principal residence to minimize taxes by combining
IRC §1031 and §121

When the Exchanger’s principal residence is used partially for business purposes, such as a home office or duplex, half of which is rented, then the Exchanger must allocate it between the personal use and business use. The portion allocated to business purposes qualifies for an IRC §1031 exchange and the residence portion may qualify for the exclusion from capital gain for personal residences under IRC §121. Section 121 permits an exclusion from capital gain realized of $250,000 for a single person and $500,000 for a married couple on the sale of a home used as a primary residence for any two of the past five years. If, however, the residence was acquired as a replacement property in a §1031 exchange, the Exchanger must have held the property for a total of five years before it qualifies for the §121 capital gain exclusion on sale. IRC §1031 permits the deferral of capital gain realized by exchanging the property held in a trade or business or for investment for like-kind investment or business use property of equal or greater value. Obviously, the Exchanger’s principal residence will not qualify for a §1031 exchange, but if, for example, the residence is converted for use as a rental for two years, it may qualify both for a §1031 exchange as property used in a trade or business and also for the §121 exclusion when it is sold. On February 4, 2005 the IRS issued Revenue Procedure 2005-14 providing guidance on the concurrent application of IRC §121 and §1031. Naturally, consultation with a tax advisor is important whenever an Exchanger changes how the intend to hold property.