Revenue Procedure 2005-14 provides guidance on tax reporting issues under IRC §121 and §1031 for exchanges of property that are combination or dual-use residential and business/ investment property.
Background - A homeowner can exclude gain from the sale of a personal residence if he owned and used the property as his principal residence for at least two of the five years preceding the date of sale (IRC §121). The maximum amount of gain exclusion is $250,000 ($500,000 married filing joint). However, the maximum amount of gain exclusion is reduced by a fraction for any rental use (non-qualified use) of the residence occurring after January 1, 2009 compared to the total years of ownership. And, any depreciation taken on the property since May 6, 1997 is not eligible for the exclusion.
Treasury Regulation 1.121-1 issued in 2002 made it clear that the IRC §121 exclusion of gain on the sale of a personal residence applies to an entire structure that is used partly as a personal residence and partly for business or investment use. The business/investment portion of a combination or dual-use residential property is also eligible for tax deferral under IRC §1031.
Accordingly, residential property may be eligible for the §121 exclusion and §1031 tax deferral under both provisions of the Internal Revenue Code simultaneously. Revenue Procedure 2005-14 gives six examples of how to report exchanges of property eligible for exclusion under IRC §121 and §1031 in varying circumstances that can be summarized by the following examples. For purposes of these examples, assume the taxpayer is single and eligible for a gain exclusion of $250,000 under IRC §121. In practice, the maximum exclusion will probably have to be reduced for non-qualified use after January 1, 2009.
Rental Property Converted from a Personal Residence in a Prior Year. IRC §121 does not require a taxpayer to be residing in a residence at the date of sale in order to qualify for the gain exclusion. If the taxpayer owned and lived in a residence in two out of the past five years, it is eligible for gain exclusion under IRC §121 even if it is presently being used as a rental. The taxpayer can exclude gain up to $250,000 under IRC §121 except for any depreciation taken on the property since May 6, 1997. Gain resulting from depreciation or gain in excess of the §121 exclusion is eligible for tax-deferral under IRC §1031. Realized gain is first excluded under IRC §121 and then deferred under IRC §1031. Cash boot of up to $250,000 received on the exchange would be tax-free under §121 even though the residence was used partly for investment/business purposes. Basis in the Replacement Property is increased by any gain excluded under IRC §121 in excess of cash received under IRC §121. This can get tricky, see Rev. Proc. 2005-14 for specifics.
Combination Property - One Property, Two Structures. If a taxpayer owns a property with a residence on it and a second structure used for business purposes, the property is a combination property. Part of the property is eligible for gain exclusion under IRC §121 and part of the property is eligible for tax-deferral under §1031. The exchange has to be accounted for as if there were two properties being sold and exchanged. The value of the Replacement Property has to be allocated between personal and business uses and realized gain is measured separately for each property. If the exchange of the business use of the Relinquished Property for business use Replacement Property results in a trade-down, there will be taxable boot on the exchange of the business portion of the Relinquished Property. Gain attributable to the business portion of the Relinquished Property cannot be excluded under IRC §121 or vice versa. Basis in the Replacement Property is measured separately for the personal residence and business portions of the property under the normal rules.
Dual Use Property - One Structure Used Partly for Residential and Business Uses. Any gain resulting from cash or debt reduction boot realized on the exchange will be tax-free up to $250,000 under IRC §121 even if the gain is allocable to or results from a trade-down on the business portion of the Relinquished Property. That is, except for any depreciation taken on the Relinquished Property since May 6, 1997. However, gain resulting from depreciation taken on the property since May 6, 1997 is also eligible for tax-deferral under IRC §1031. Variations on this theme can be summarized as follows:
- All gain on the Relinquished Property up to a maximum of $250,000 can be excluded under IRC §121 except for depreciation taken on the property since May 6, 1997. Depreciation taken on the property that is allocable to the 1031 portion of the property can be tax-deferred under IRC §1031. Depreciation on the property after May 6, 1997 that is allocable to the personal residence portion of the property cannot be deferred under §1031.
- Cash (or debt reduction) boot received on the exchange is tax-free under IRC §121 up to a maximum of $250,000 even if it relates to the 1031 portion of the property. (Except for post May 6, 1997 depreciation).
- Gain on the exchange allocable to the personal residence portion of the property in excess of $250,000 is taxable under IRC §121 and cannot be sheltered under IRC §1031.
Revenue Procedure 2005-14 does not address closing issues on exchanges of property used partly for residential purposes and partly for investment/business uses. Treasury Department Publication 523 (1998, now replaced by new Pub. 523) instructed taxpayers with Dual-Use Property to treat the sale as two sales. Intermediaries frequently separate an exchange of dual-use property in a similar manner with separate settlement statements so that the taxpayer can cash-out on the personal residence part and roll the 1031 part thru an exchange. As a result of Rev Proc 2005-14, this is no longer necessary for Dual-Use Property. Whatever cash is pulled out of the exchange of dual use property is allocated first to the personal residence. Separate settlement statements remain desirable for sales of Combination Property since all data will have to be prorated for Combination Property.
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