Exploring IRS Section 121- Excluded Gain On Sale Of Residence- Part 3 of 4- Converting a Rental To A Primary Residence After A 1031 Exchange
The Taxpayer Relief Act of 1997 created IRC Section 121, which allows a homeowner to exclude up to $250,000 of gain on the sale of a primary residence (or up to $500,000 for a married couple filing jointly). In order to qualify, the homeowner(s) must own and also use the home as a primary residence for at least 2 of the past 5 years. In the case of a married couple, the requirement is satisfied as long as either spouse owns the property, though both must use it as a primary residence to qualify for the full $500,000 joint exclusion.
The use does not have to be the final 2 years, just any of the past 2-in-5 years that the property was owned. Thus, for instance, if an individual bought the property in 2010, lived in it until 2012, moved somewhere else and tried to sell it, but it took 2 years until it sold in 2014, the gains are still eligible for the exclusion because in the past 5 years (since 2010) the property was used as a primary residence for at least 2 years (from 2010-2012). The fact that it was no longer the primary residence at the time of sale is permissible, as long as the 2-of-5 rule is otherwise met.
If a sale occurs and it has been less than 2 years, a partial exclusion may still be available if the reason for the sale is due to a change in health, place of employment, or some other “unforeseen circumstance” that necessitated the sale. In such scenarios, a pro-rata amount of the exclusion is available; for instance, if an individual had to sell the home after 18 months instead of the usual 24, the available exclusion would be 18/24ths multiplied by the $250,000 maximum exclusion, which would provide a $187,500 maximum exclusion (which will likely still be more than enough, as it’s unlikely that the gain would be more than this amount unless it was an extremely large house!).
Converting Rental Property Into A Primary Residence After A 1031 Exchange
Congress added an “anti-abuse” rule as it applies to rental property converted to a primary residence that was previously subject to a 1031 exchange. This is a situation where an individual completes a 1031 exchange of a small apartment building into a single family home, rents the single family home for a period of time, then moves into the single family home as a primary residence, and ultimately sells it (trying to apply the primary residence capital gains exclusion to all gains cumulatively back to the original purchase, including gains that occurred during the time it was an apartment building!). To limit this, American Jobs Creation Act of 2004 (Section 840) introduced a new requirement (now IRC Section 121(d)) that stipulates the capital gains exclusion on a primary residence that was previously part of a 1031 exchange is only available if the property has been held for 5 years since the exchange.
Example 1a. Steven’s original ownership since 2000 was of an apartment building, and in early 2011 he had completed a 1031 exchange to a single family home, with the ultimate intention of moving into the property as a primary residence to claim the capital gains exclusion. Even if Steven moves into the property in early 2013 and lives there for 2 years, he will not be eligible for any capital gains exclusion until 2016 (five years after the 1031 exchange). At that time, he can complete the sale and be eligible for the exclusion. He will still have 4 years of non-qualifying use (2009 after the effective date, though the end of 2012 when the property was still a rental), but will now have 12 years of qualifying use (2000-2008 inclusive, and 2013-2016), which means 12/16ths of his gains will be eligible for the exclusion and 4/16ths will be deemed non-qualifying use capital gains and subject to taxes (in addition to any depreciation recapture).
Fortunately, while the rules do limit the exclusion of capital gains attributable to periods of non-qualifying use (after 2009) in the case of a rental property converted to a primary residence, the rules are more flexible in the other direction, where a primary residence is converted into a rental property. IRC section 121(b)(4)(C)(ii)(I) allows taxpayers to ignore any non-qualifying use that occurs after the last date the property was used as a primary residence, though the 2-of-5 ownership-and-use tests must still be satisfied.