Business Property Sales Under Secs. 1031 and 121

In July 1999, Congresswoman Jennifer Dunn (R-WA) proposed an amendment to Sec. 121. Under this proposal, an exclusion of gain would not apply to any principal residence acquired by a taxpayer in a like-kind exchange under Sec. 1031 in the past 10 years. To understand why this amendment was proposed, a review of Sec. 121 is in order.

Sec. 121

The Taxpayer Relief Act of 1997 radically changed the income tax treatment of the sale or exchange of a principal residence. Under Sec. 121(b)(2), for the sale of a principal residence on or after May 7, 1997, married couples filing jointly may exclude up to $500,000 of gain ($250,000 for singles) if:

1. Either spouse owned the home for at least two years in the five-year period ending on the sale date;

2. Both spouses used the home as a principal residence for at least two years in the five-year period ending on the sale date; and

3. Neither spouse used this new gain exclusion within the last two years.

Old and New Rules

New Sec. 121 replaced the Sec. 1034 rollover of gain provisions and the old Sec. 121 one-time $125,000 exclusion for taxpayers age 55 or older. New Sec. 121 has three important advantages over the prior rule:

• The availability of an exclusion on the sale of a residence at any time during a taxpayer's life;
• No lifetime limit on the use of the exclusion; and
• Applicability of the exclusion to all of the gain realized at the time of sale, not just the gain attributable to the residence's appreciation while it was a principal residence.

The law, however, does not require that the home sold be the taxpayer's principal residence at the time of sale. Nor does it require the taxpayer to have owned the home for five years. Instead, the taxpayer must have used the home as his principal residence for two years or more within the five-year period ending on the sale date. Therefore, using the Sec. 212(a) exclusion, taxpayers could live in one home for two years, move into their vacation home and convert it to their principal residence, and have up to three more years to sell their old principal residence. However, under Sec. 121(d)(6), the exclusion does not apply (and gain is recognized) to the extent of any depreciation adjustments, when a principal residence was used for business purposes after May 6, 1997.

Sec. 1031

Taxpayers who currently own substantially appreciated real estate used in a trade or business or held for investment may face a large tax bite when they sell their property. One way to defer a taxable gain is via a like-kind exchange (Sec. 1031). Under Sec. 1031, a taxpayer may exchange qualifying property without currently recognizing realized gain or loss. To qualify for Sec. 1031 nonrecognition treatment, the property transferred and the property acquired must be of a like-kind and held for productive use in a trade or business or for investment purposes (i.e., rental property). The amount of gain deferred under Sec. 1031 is not subject to the $250,000/$500,000 limits of Sec. 121. The taxpayer's basis of property acquired in a Sec. 1031 exchange is not its cost. Basis is determined instead by the transferred property's basis or Sec. 1031(d)'s substituted basis. Therefore, the gain is truly deferred until the newly acquired property is sold for cash, unless a taxpayer applies the following strategy.

Strategy: Secs. 1031 and 121

To secure treatment under Sec. 1031 for newly acquired residential rental property received in a like-kind exchange, a taxpayer should continue to hold the property as rental property for some period of time. If the taxpayer later converts the property to his principal residence and then uses it as such for a minimum of two years, a subsequent sale of the property will fall under the Sec. 121 exclusion rules if the taxpayer is otherwise eligible. Any realized gain (either deferred or post-exchange appreciation) in excess of $500,000 ($250,000 if single) is taxable at the time of sale. Further, any gain to the extent of depreciation claimed after May 6, 1997 would be taxable as required under Sec. 121(d)(6).

Example: J and K are married and own a commercial office building that they lease to a dentist. The couple purchased the building many years ago for $150,000 and have claimed $150,000 in depreciation using the straight-line method, leaving them with a zero basis. The office building's current fair market value (FMV) is $250,000. If J and K were to sell the office building for cash, they would incur a $250,000 taxable gain.

Alternatively, J and K could exchange the office building under Sec. 1031 for a home that they rent out and hold as residential rental property for some period of time after the exchange. The couple could then convert the home into their principal residence and use it as such for a two-year minimum. If the home's FMV at the end of the two-year period is $275,000, J's and K's realized gain on a cash sale would be $275,000 (i.e., the $25,000 appreciation on the home while they owned it and the $250,000 gain they deferred from the like-kind exchange). Assuming that all depreciation claimed by J and K occurred prior to May 7, 1997, they could exclude the entire $275,000 gain on the sale of their home under Sec. 121.

To date, no recognized authorities have indicated this type of transaction is unlawful. Rep. Dunn considers this a tax loophole, which is the rationale behind her proposed amendment to Sec. 121. Unless this proposal receives support in Congress and is approved, tax advisers should continue to execute this type of transaction on behalf of their clients while it is still available.

From Chang Cho, Minneapolis, MN