|
|
 |
|
March 2007 1031 exchange and the sale of a principal residence A two-year-old IRS revenue procedure has lasting value that merits a review For sophisticated real estate investors and developers, IRS Revenue Procedure 2005-14, 2005-7 IRB clarified 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. If properly structured, that exclusion offers opportunities that are significant enough to warrant a review. 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 as the taxpayer’s principal residence, so long as it is one dwelling unit. 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. Revenue Procedure 2005-14, 2005-7 IRB provided six examples of how IRC §§ 1031 and 121 can work together. These examples break down into three basic scenarios. Scenario 1: Sequential Use. John exchanges a single property that he had used initially as a principal residence for two of the five years prior to the exchange. Before the exchange, he had converted it to a rental property that he held for investment. In this situation, all realized gain, except for 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 of gain excluded under IRC § 121. Scenario 2: Concurrent Use – Two Units. Mary exchanges property consisting of two separate dwelling units: a house and a guesthouse. Mary used the house (for at least the two prior years) as a principal residence and the guesthouse as the office for her 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. Scenario 3: Concurrent Use – One Unit. Tom exchanges a single property consisting of one dwelling unit that is used partially as a principal residence and partially in a trade or business. Tom may use IRC § 121 to exclude gain on both portions of the property. He 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. Do Not Try This at Home. The Revenue Procedure discussed in this article provides ample opportunities for properly structured like-kind exchanges that preserve the exclusions allowed under IRC § 121. Maximizing the benefits of those opportunities requires the services of a professional who is experienced in this area. For assistance in structuring your next like-kind exchange, please contact your Schmidt Westergard & Company professional. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
