Sale of a Residence and Like-Kind Exchanges (Part II)

This two-part article examines how recent developments in the principal residence exclusion and like-kind exchanges affect mixed personal- and business-use property. Part II examines how Rev. Proc. 2005-14 applies Secs. 121 and 1031 to sales and like-kind exchanges of such property.

Kenneth N. Orbach, Ph.D., CPA
Professor of Accounting
Florida Atlantic University
Boca Raton, FL       

Steve Dilley, Ph.D., J.D., CPA
Professor of Accounting
Michigan State University
East Lansing, MI

For more information about this article, contact Prof. Orbach at orbach@fau.edu or Prof. Dilley at dilleys@bus.msu.edu.

Editors note: Prof. Orbach is a member of the AICPA Tax Divisions Tax Executive Committee.

Executive Summary

• Rev. Proc. 2005-14 provides five basic principles for applying the Sec. 121 residence exclusion and Sec. 1031 like-kind exchange rules to mixed-use property.

• The tax consequences of a sale and exchange of mixed-use property vary according to the facts.

• Tax advisers should warn clients that the Sec. 121 exclusion is not available for five years after replacement property is received in a like-kind exchange.
   

This two-part article analyzes how a mixed-use property (i.e., some use as both a principal residence and as a business property) is handled for purposes of the Sec. 121 principal residence exclusion and Sec. 1031 like-kind exchange rules. Part I, in the November 2005 issue, explained the general interaction between Secs. 121 and 1031. Part II, below, describes and illustrates in detail the principles applicable to mixed-use property under Rev. Proc. 2005-14.²³

Rev. Proc. 2005-14

Basic Principles

Principle #1: Taxpayers within the scope of the procedure may apply both the Sec. 121 exclusion and the Sec. 1031 nonrecognition provisions to the same transaction.

Principle #2: The Sec. 121 gain exclusion is applied before Sec. 1031 gain postponement.

Principle #3: The post-May 6, 1997 depreciation-related gain otherwise recognized under Sec. 121 may be postponed under Sec. 1031.

Principle #4: In applying Sec. 1031, boot is taken into account only to the extent it exceeds the Sec. 121 excluded gain attributable to the relinquished business property.

Principle #5: The basis of the replacement trade or business or investment property is increased by the Sec. 121 excluded gain (i.e., the excluded gain is treated as additional recognized gain for purposes of the Sec. 1031(d) calculation of the replacement propertys basis²⁴).

Examples

These principles are illustrated in the examples below.

Example 1Single dwelling unit, no mixed use at sale: Single taxpayer A purchased a house on Jan. 3, 2000 for $200,000 and immediately resided in it. She previously lived in a rental apartment. A used the house as her principal residence until Dec. 31, 2004, when she moved in with her fianc. Under Sec. 121, A has until Dec. 31, 2007 to sell or exchange the house and still qualify for an exclusion. In other words, she has a three-year window within which she continues to qualify for exclusion under Sec. 121.²⁵ From Jan. 1, 2005 until June 30, 2006, A rents the house to tenants and claims $10,900 depreciation.²⁶ On July 1, 2006, A exchanges the house for $10,000 and a townhouse (building and land) with a $435,000 FMV. A rents the townhouse to tenants.

Because A owned and used the house for at least two years during the five-year period ending on July 1, 2006 (the exchange date), she may exclude her gain under Sec. 121.²⁷ Because the property is rental property on July 1, 2006, and A intends to hold the townhouse as rental property, Sec. 1031 also applies. Under Rev. Proc. 2005-14, Sec. 121 applies first (Principle 2). The tax consequences of the exchange follow.

1. Compute realized gain without regard to Secs. 121 and 1031:

2. Apply Sec. 121: Sec. 121 does not apply to the first $10,900 (the depreciation taken on the relinquished house) of realized gain, under Sec. 121(d)(6). The remaining $245,000 gain is excluded from income under Sec. 121.

3. Apply Sec. 1031: Because the $245,000 excluded gain exceeds the $10,000 boot received, the entire $10,900 post-exclusion realized gain is deferred (i.e., not currently recognized) by Sec. 1031 under Rev. Proc. 2005-14, Section 4.02(3) (Principles 3 and 4). As basis in the replacement townhouse is $424,100 ($435,000 townhouse FMV $10,900 deferred gain); this amount may also be computed as $189,100 basis of the relinquished house + $245,000 excluded gain $10,000 boot received (Principle 5).

Alternative analysis: Because A has received more than one like-kind property (the townhouse consists of a building and land), the transaction is a multiple-property exchange for Sec. 1031 purposes.²⁸ Under Regs. Sec. 1.1031(j)-1, the properties in the July 2006 transaction are separated as follows:

1. The only exchange group in this example consists of (1) the replacement townhouse (land and building) with a $435,000 FMV and (2) the relinquished house with a $189,100 basis and a $445,000 FMV ($255,900 realized gain).²⁹

2. Because the relinquished houses value exceeds the replacement townhouses value by $10,000, the $10,000 received by A goes into the residual group.³⁰

The tax consequences are determined as follows:

1. Apply Sec. 121: Sec. 121 does not apply to the first $10,900 (the depreciation taken on the relinquished house) of the $255,900 realized gain, under Sec. 121(d)(6). The remaining $245,000 gain is excluded under Sec. 121.

2. Apply Sec. 1031: Because A excludes $245,000 of the realized gain, the amount realized on the house is reduced by $245,000 to $200,000 for Sec. 1031 purposes.³¹ Thus, there is an exchange group surplus of $235,000 ($435,000 FMV of the townhouse received $200,000 reduced amount realized on the relinquished house). Because there is no exchange group deficiency, no gain is recognized therein.³²

Under Regs. Sec. 1.1031(j)-1(c), the replacement townhouses basis is $424,100 ($189,100 basis of the relinquished house + $235,000 exchange group surplus), which is allocated to the townhouse building and land pro rata, according to FMVs. The tax ramifications are summarized in Exhibit 1.

Note: The gain excluded from As income was $5,000 less than her $250,000 maximum gain exclusion. However, there is no carryover of this $5,000 to the replacement property. Because A did not occupy the replacement townhouse as her principal residence at any time, it is not eligible for a Sec. 121 exclusion.

Example 2Sec. 121(d)(10): The facts are the same as in Example 1, except that A converts the replacement townhouse from rental use to her principal residence on Jan. 1, 2007, because she and her fianc broke up. Unfortunately, because A acquired the townhouse in a Sec. 1031 transaction, Sec. 121(d)(10), as added by American Jobs Creation Act of 2004 Section 840(a), precludes a Sec. 121 exclusion on As subsequent sale (or exchange) of the townhouse within five years of its acquisition. Thus, although A would otherwise be eligible for a Sec. 121 exclusion as of Jan. 1, 2009, Sec. 121(d)(10) forces her to hold the property until July 1, 2011 to be eligible for it.

If A wishes to avoid this result, she must avoid Sec. 1031 treatment on her acquisition of the townhouse. Because the latter is a mandatory provision, she would have to deliberately fail one of its conditions. For example, A could hold the house (the property she exchanged for the townhouse) for personal use (not necessarily as her principal residence) after the rental period and before exchanging it for the townhouse.³³ Or, she could hold the townhouse for personal purposes immediately after the exchange. Assuming either such personal use has substance, (1) Sec. 1031 will not apply to the exchange of the house, (2) A will recognize $10,900 unrecaptured Sec. 1250 gain,³⁴ (3) A will have a $435,000 basis in the townhouse immediately after its acquisition and, most importantly, (4) Sec. 121(d)(10) will not apply to bar a Sec. 121 exclusion on a subsequent sale.³⁵ Because the recognized gain is only $10,900, it may be worth failing Sec. 1031 treatment to gain flexibility in the disposition date of the replacement townhouse.³⁶ The tax ramifications are summarized in Exhibit 2.

Example 3Single dwelling unit, mixed use at sale: Single taxpayer B bought a property in January 2001 for $210,000, consisting of a house (and underlying land) that constitutes a single dwelling unit under Regs. Sec. 1.121-1(e)(2). From 2001 through Dec. 31, 2005, B uses two-thirds of the house (by square footage) as his principal residence (relinquished residence) and one-third of the house as an office in his trade or business (relinquished office). B properly claims $9,000 depreciation on the relinquished office. On Jan. 1, 2006, B exchanges the entire property for the following:

Because the relinquished residence and the relinquished office constitute a single dwelling unit, the Regs. Sec. 1.121-1(e)(3) allocation does not apply. However, the same result obtains, under case and administrative law.³⁷ Thus, two-thirds of the amount realized ($240,000) is allocated to the exchange of the relinquished residence; one-third of the amount realized ($120,000) is allocated to the exchange of the relinquished office. The tax consequences of the exchange follow:

B has received more than one like-kind property (the replacement office building and its underlying land), making the transaction a multiple-property exchange for Sec. 1031 purposes. Under Regs. Sec. 1.1031(j)-1, the properties involved in the Jan. 1, 2006 transaction are separated as follows:

1. The only exchange group in this example consists of (i) the replacement office (building and land) with a $150,000 FMV and (ii) the relinquished office with a $61,000 basis and $120,000 FMV³⁸ ($59,000 realized gain).³⁹

2. The FMV of the replacement property in the exchange group exceeds that of the relinquished property by $30,000; thus, there is a residual group consisting of a $30,000 undivided interest in the relinquished residence.⁴⁰ The basis of this undivided interest is $17,500.⁴¹

3. In a transaction outside of the exchange and residual groups, B receives the replacement residence ($180,000 FMV) and $30,000 in exchange for the remaining $210,000 undivided interest in the relinquished residence, with a basis of $122,500 ($140,000 $17,500).

The tax consequences are computed as follows:

1. Apply Sec. 121: First, B realizes $12,500 gain ($30,000 $17,500) on the undivided interest in the relinquished residence in the residual group, and $87,500 gain ($180,000 + $30,000 $122,500) on the undivided interest in the relinquished residence, taken into account outside of the exchange and residual groups. The $100,000 ($12,500 + $87,500) total gain is excluded under Sec. 121.

Second, because the relinquished residence and relinquished office constitute a single dwelling unit, the remaining $150,000 of the Sec. 121 limit is available to exclude part of the realized gain on the exchange of the relinquished office.⁴² However, under Sec. 121, B can exclude only $50,000 of the $59,000 realized gain ($120,000 $61,000)⁴³ in the exchange group; under Sec. 121(d)(6) and Regs. Sec. 1.121-1(d), B may not exclude the $9,000 gain attributable to depreciation on the relinquished office.

2. Apply Sec. 1031: Because, under Sec. 121, B can exclude $50,000 of the realized gain on the disposition of the relinquished office, the amount realized for the relinquished office is reduced by $50,000 to $70,000, for Sec. 1031 purposes.⁴⁴ Thus, the exchange group surplus is $80,000 ($150,000 FMV of the replacement office $70,000 reduced amount realized for the relinquished office). There is no exchange group deficiency; thus, no gain is recognized therein. Under Regs. Sec. 1.1031(j)-1(c), the basis of the replacement office is $141,000 ($61,000 basis of the relinquished office + $80,000 exchange group surplus), which is allocated to the building and land pro rata according to their FMVs. The basis of the replacement residence is its $180,000 FMV. The tax ramifications are summarized in Exhibit 3.

Example 4Business property separate from dwelling unit at sale: Single taxpayer C bought property in January 2001 for $210,000, consisting of two separate dwelling units (within the meaning of Regs. Sec. 1.121-1(e)(2))a house and a guesthouse. From 2001 through the end of 2005, C uses the house as her principal residence and the guesthouse as an office in her trade or business. C allocates two-thirds of the basis to the house and one-third of the basis to the guesthouse, based on square footage. She properly claims $9,000 depreciation on the guesthouse. On Jan. 1, 2006, C exchanges the entire property for the following:

The house and the guesthouse do not constitute a single dwelling unit; thus, Regs. Sec. 1.121-1(e)(3) applies to allocate two-thirds of the amount realized ($240,000) to the exchange of the house and one-third of the amount realized ($120,000) to the exchange of the guesthouse. The remaining analysis for Example 4 is the same as that in Example 3 except that, under Regs. Sec. 1.121-1(e)(1), no part of the realized gain on the guesthouse is subject to the Sec. 121 exclusion, because the house and guesthouse are not part of the same dwelling unit. The tax consequences of the exchange follow.  

As in Example 3 above, because C has received more than one like-kind property (the replacement office building and underlying land), the transaction is a multiple-property exchange for Sec. 1031 purposes. Under Regs. Sec. 1.1031(j)-1, the properties involved in the Jan. 1, 2006 transaction are separated as follows:

1. The only exchange group in this example consists of the (i) replacement office (building and land) with a $150,000 FMV and (ii) relinquished guesthouse with a $61,000 basis and a $120,000 FMV ($59,000 realized gain), as in Example 3.

2. Because the FMV of the replacement property in the exchange group exceeds that of the relinquished property therein by $30,000, there is a residual group consisting of a $30,000 undivided interest in the house. The basis of this undivided interest is $17,500, as in Example 3.

3. In a transaction outside of the exchange and residual groups, C receives the replacement residence ($180,000 FMV) and $30,000 in exchange for the remaining $210,000 undivided interest in the house, with a basis of $122,500 ($140,000 $17,500), as in Example 3.

The tax consequences are computed as follows:

1. Application of Sec. 121: First, as in Example 3, C realizes $12,500 gain ($30,000 $17,500) on the undivided interest in the house in the residual group and $87,500 gain ($180,000 + $30,000 $122,500) on the undivided interest in the house taken into account outside of the exchange and residual groups. The $100,000 ($12,500 + $87,500) total gain is excluded under Sec. 121.

Second (the analysis now diverges from that in Example 3), because the house and guesthouse do not constitute a single dwelling unit, no part of the remaining $150,000 of the Sec. 121 limit is available to exclude any of the realized gain on the exchange of the guesthouse.⁴⁵

2. Application of Sec. 1031: The exchange group surplus is $30,000 ($150,000 replacement office FMV $120,000 realized for the relinquished guesthouse). Because there is no exchange group deficiency, no gain is recognized therein. Under Regs. Sec. 1.1031(j)-1(c), the replacement offices basis is $91,000 ($61,000 basis of the relinquished guesthouse + $30,000 exchange group surplus), which is allocated to the building and land pro rata according to their FMVs. The basis of the replacement residence is its $180,000 FMV; see Exhibit 4 for a summary of the tax ramifications.

Example 5Single dwelling unit, no mixed use at sale: The facts are the same as in Example 1, except that the replacement townhouse has a FMV of $190,000 and A receives $255,000 (in addition to the replacement townhouse). Thus, As amount realized is $445,000, as in Example 1. The exchange group now consists of the replacement townhouse (land and building), with a $190,000 FMV and the relinquished house with a $189,100 basis and $445,000 FMV. Because the relinquished houses FMV exceeds the townhouses FMV by $255,000, the $255,000 received by A goes into the residual group.

As in Example 1, A excludes $245,000 gain under Sec. 121, which reduces to $200,000 the amount realized on the house for Sec. 1031 purposes. Thus, there is an exchange group deficiency of $10,000 ($200,000 reduced amount realized for the relinquished house $190,000 FMV of the townhouse). Under Regs. Sec. 1.1031(j)-1(b)(3)(i), the gain recognized is $10,000, computed as the lesser of the $10,900 (post-exclusion) gain realized ($200,000 $189,100) or the $10,000 exchange group deficiency. The $10,000 gain recognized is unrecaptured Sec. 1250 gain.⁴⁶ Under Regs. Sec. 1.1031(j)-1(c), A has a $189,100 basis in the replacement townhouse ($189,100 basis in the relinquished house + $10,000 recognized gain $10,000 exchange group deficiency). The tax ramifications are summarized in Exhibit 5.

Most importantly, consistent with Principle 4, the $10,000 (post-exclusion) exchange group deficiency equals the excess of the $255,000 boot (cash in this example) received over the $245,000 Sec. 121 excluded gain; As $189,100 basis in the replacement townhouse equals that determined under Principle 5 ($189,100 basis in the relinquished house + $10,000 recognized gain + $245,000 excluded gain $255,000 boot received). In other words, reduction of the amount realized on the relinquished exchange group property by the gain excluded under Sec. 121 is equivalent to Principles 4 (boot in excess of excluded gain) and 5 (excluded gain included in basis).

Conclusions and Planning Suggestions

The combination of Sec. 121(d)(10) and Rev. Proc. 2005-14 has clarified some very confusing aspects of the Sec. 121/1031 interaction. However, very careful attention to the facts is a basic requirement when attempting to apply the law. With respect to Sec. 121(d)(10), tax advisers should be careful to warn clients not to sell a replacement property until it has been held at least five years. Clients with exposure to Sec. 121(d)(10) are those who have received (replacement) property in a like-kind exchange within the last five years, who have included a Schedule E for such property and who now are using it as a principal residence. Under Rev. Proc. 2005-14, the depreciation base for the replacement property can be drastically affected, because the excluded Sec. 121 gain is added to the replacement propertys basis. When relinquished property has a mixed use (business and personal) at the time of the Sec. 121/1031 exchange, allocation of the amount realized and the basis of the property is required. As shown in the examples in this article, the calculations may be quite complex.

Because a sale of mixed-use property is common for many taxpayers and like-kind exchanges are increasingly popular, the applicability of the provisions discussed in this article will continue to grow.