This is the second part of a three-part series explaining the basics of the tax-deferred 1031 exchange, the different types available, the mechanics of how they work, and the benefits to be reaped by a client who decides to partake in such an exchange. To view Part 1, please click here.

Guidance From the IRS in Revenue Procedure 2005-14

The Internal Revenue Service now acknowledges that both the IRC § 121principal residence tax exclusion and like-kind IRC § 1031 tax deferred exchange rules can apply in the same transaction under Revenue Procedure 2005-14. However, as the following illustrates, some taxpayers will benefit from the principal residence income tax exclusion even after having converted the entire premises to investment (e.g., rental) or business-use property under the revenue procedure. This also may apply to real estate simultaneously used part as principal residence (e.g., two-thirds) and part as investment or business use property, such as a rental (e.g., one-third).

A. An Example of the Application of JRC § 121 to the Sale of a Principal Residence

Suppose a taxpayer back in 1970 bought a co-op in Manhattan for $200,000, which today is worth $3 million. That person and her spouse have both used that home as their principal residence for all these years, but they now wish to retire and move elsewhere. A sale of that home for $3 million will generate $2.8 million of taxable gain. After subtracting the $500,000 principal residence income tax exclusion under IRC § 121, the couple will recognize $2.3 million of taxable gain. The federal income tax, using the maximum 15% capital gains tax rate, will be $345,000. Further, New York State and City income taxes will also apply.

Assuming this person is already in the maximum tax bracket, the New York State personal income tax bracket in 2005 would then equal 7.7% of the gain, or $177,100, while New York City personal income tax in 2005 would then equal 4.45% of $2.3 million, or $102,350. Thus, the aggregate tax burden would equal $624,450, which works out to a total effective tax rate of 27.15% on the taxable gain. While federal income tax law allows an itemized deduction on Federal Schedule A for state and local income taxes paid during the tax year in computing federal taxable income, which can be an offsetting benefit, itemized deductions (such as for state and local income taxes) be phased out once income starts to exceed certain levels, so the benefit of any such deduction may be lost in large part under IRC § 68. For example, in tax year 2004, itemized deductions begin to phase out at $142,700 for a married couple filing jointly under Revenue Procedure 2003-85.

B. Application of Revenue Procedure 2005-14 to a Principal Residence Entirely Converted to a Rental Property

Rather than sell the home when the couple moves elsewhere, the couple could now instead decides to rent the Manhattan co-op (assuming that is permissible). After less than three years of rental, they sell the co-op for a combination of $500,000 cash and a replacement property whose receipt would satisfy the IRC § 1031 like-kind tax deferred exchange rules. The replacement property could even be a co-op or a home that they would then rent out to third parties, which makes that an eligible business property. In fact, for this couple, the rental income could be a useful supplemental retirement source of annual income. Three principal tax benefits are noted in Revenue Procedure 2005-14.

First, Revenue Procedure 2005-14 concludes that the $500,000 of cash can be received tax- free under the principal residence income tax exclusion. Under Section 4.02
 (3) of this procedure, it should be noted that with respect to the treatment of boot, “In applying § 1031, cash or other non-like kind property (boot) received in exchange for property used in the taxpayer's trade or business or held for investment (the relinquished business property), is taken into account only to the extent the boot exceeds the gain excluded under § 121 with respect to the relinquished business property.”

Prior to this revenue procedure, taxpayers may have wondered how that can be the case since the property, when sold, was no longer a principal residence. The answer is that to be eligible for the principal residence income tax exclusion, the property need only have been used as a principal residence for at least two years in the five-year period ending on the date of the disposition under IRC § 121(a). In the Revenue Procedure 2005-14, as in the example, the taxpayer satisfies that test with respect to the home. By having rented it for “fewer than three years” in the last five years, the taxpayer has used the home as principal residence for at least two years. Thus, the IRS concluded the home was eligible for the principal residence income tax exclusion. (See Revenue Procedure 2005-14, § 5, Example 1.)

Second, the IRS concluded in the Revenue Procedure 2005-14 that the home was, as the property could be a part of a tax-deferred IRC § 1031-like kind exchange. Thus, as long as the replacement properly is eligible property, namely, business or investment property and not property that will be used as a personal residence, the tax-free benefits of the like-kind exchange rules can be applied so that no income tax arises from receipt of the replacement property. For a discussion of this, see the New York Law Journal issue for Monday, September 19, 2005 for the article by Michael Hirschfield, Esq., "A New Twist to Reducing Tax Bills on Home Sales.”

C. Application of Revenue Procedure 2005-14 to a Single Structure That is Part Principal Residence and Part Business/Investment (e.g., Rental)

In addition to the above, it is also important to note that under the proper circumstance, Revenue Procedure 2005-14 provides that any excess principal residence exclusion under IRC § 121 can be applied to the investment/business use portion the same single structure. It is under Section 4.02 (1,2) of this revenue procedure that any IRC § 121 principal residence exclusion unused by the principal residence can be applied to gain from investment or business use property that is part of a single structure where the principal residence also exists—except to the amount attributable to depreciation deductions for periods after 5/6/97—before calculating taxable gain or even the application of an IRC § l 031 tax-deferred exchange. Any balance of gain on the investment/business use portion—including the amount of gain represent accumulated depreciation (i.e., depreciation deductions referred to above)—will be taxed unless the taxpayer engages in an IRC § l031 tax-deferred exchange. So long as a qualified intermediary receives funds in accordance with IRC § 1031 and its Treasury Regulations—including § 1.103l(K)—then all the projected tax may be deferred.

ADDENDUM TO ARTICLE EDITORIAL NOTE:

The following case; Revenue procedure; and congressional tax act slightly amends the text of the article.

I. In Moore v. Commissioner, T.C. Memo 2007-134, the taxpayers sold their vacation home and purchased another vacation home using a Qualified Intermediary under IRC § 1031. The Internal Revenue Service determined and the Tax Court agreed that the taxpayers were not entitled to exclude the gain from the sale of the first vacation home under Internal Revenue Code § 1031, because the properties were not held primarily for use in a trade or business investment. The Tax Court ruled that holding the property because its value was expected to increase was insufficient to qualify the transaction for Code § 1031 gain exclusion. The evidence in the case established that the couple and their children used the property as a vacation retreat on weekends about 26 days each year, did not rent it or claim depreciation or investment interest expenses on it nor ever held the property out as rental during any year.

II. Shortly after the case in 2008 the Internal Revenue Service issued Revenue Procedure 2008-16 Safe Harbor for Exchanges of Vacation Homes and Conversions to or from Personal Residences.

The Revenue Procedure states that the relinquished property and the replacement property will both qualify for an Internal Revenue Code § 1031 exchange if the properties are owned by the taxpayer for 24 months immediately before and after the exchange, and in each of the two 12-month periods immediately preceding that start of the exchange and immediately after the exchange the taxpayer’s rents and property to another person at a fair rental for 14 days or more and the taxpayer's personal use of the replacement property does not exceed  the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

III. Under  the American Jobs Creation Act of 2004 when a taxpayer acquires investment residential real estate in a tax-deferred IRC Section 1031 like-kind Exchange and converts the property to a principal residential residence after properly holding the property as an investment property for two years; Internal Revenue Code § 12l(d) IO enables the taxpayer to receive a $250,000 or $500,000 income tax exclusion provided the taxpayer owns the property for at least five years and occupies the property for two years.

The 2008 Housing and Economic Recovery Act changes the rules for the exclusion of gain from the sale of a principal residence that has been converted to a principal residence after being used as an investment property. Under the new rules, taxpayers residence after being used as an investment property. Under the new rules, taxpayers will have to determine the amount of gain (if any) allocable to periods of nonqualified use, gain will be allocated to periods of nonqualified use based on the ratio that aggregate periods of nonqualified use bear to the period the taxpayer owned the property.

A period of nonqualified use is defined as any period after January 1, 2009 in which the property is 1101 used as the taxpayer's principal residence, prior to the taxpayer's occupying the property as a principal residence, The word “property” replaces the word residence to ensure broad application of the provision nonqualified use will also include the period of time that a taxpayer owns a vacant lot on which he or she intends to construct his primary residence before that residence is constructed or occupied.

Taypayers may move out of their primary residence after occupying the residence as their primary residence and can convert the property to a rental property until the property is sold and still receive the full $250,000 or $500,000 primary residence exclusion provided they meet the other requirements of IRC Section 121 such as owner occupying the property for two years within the last five years.

An example of the prior paragraph is as follows:

Mel buys on January 1, 2009, for $400,000. He rented it out for two years, and claims $20,000 in depreciation deductions during that time, On January 1, 2011, he begins using the home as his principal residence, On January 1, 2013, he moves out of the home, and on January 1, 2014, he sells the home for $700,000. The gain that is attributable to his depreciation deductions ($20,000) is included in his income. The full amount of his gain ($300,000) is allocated to his qualified and nonqualified use of the home. Thus, 40% of the gain (two years divided by five years), $120,000 is allocated to nonqualified use and is not eligible for exclusion; his remaining gain of $180,000 is fully excluded, because it is less than the maximum excludable gain ($250,000).