Gain Rollover May Apply in the Sale of a Principal Residence

By William A. Bottiglieri and Steven L. Kroleski

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JANUARY 2006 - For the sale or exchange of a principal residence occurring prior to May 7, 1997, two tax relief provisions were available to taxpayers. The first was the IRC section 121 elective, once-in-a-lifetime exclusion of up to $125,000 in gain for taxpayers who met certain age and residency requirements. The second was the IRC section 1034 mandatory deferral of any such gain (or gain remaining after the exclusion), based upon the acquisition of a replacement principal residence within two years before or after the sale. Any such gain would be deferred to the extent the adjusted sales price of the former residence (after a reduction for any excluded gain) was reinvested in a replacement residence. The Taxpayer Relief Act of 1997 repealed the once-in-a-lifetime exclusion provision in IRC section 121 and replaced it with an elective exclusion of $250,000 ($500,000 in the case of certain joint filers) and made this increased exclusion available every two years subject to residency, but not age, requirements. The 1997 Act also repealed the IRC section 1034 deferral provisions so that any gain remaining after the increased exclusion would be taxed regardless of the acquisition of a replacement residence. There are, however, two situations in which taxpayers are still permitted to defer some or all of the gain from the sale of a principal residence.

Involuntary Conversions: IRC Section 1033

For purposes of the increased IRC section 121 exclusion, the complete or partial destruction or condemnation of a property is treated as a sale under the rules governing involuntary conversions. This not only makes the IRC section 121 exclusion available, but also brings into play the IRC section 1033 provisions allowing for the deferral of gain. Under section 1033, gain will be deferred to the extent the property is replaced with like-kind property within the required time limits at a cost exceeding the amount realized from the involuntary conversion. Insurance or condemnation proceeds are treated as the amount realized from the sale. Gain will be recognized to the extent any such proceeds are not reinvested. In addition, in the event that only a part of the property is condemned, a voluntary sale of the remaining portion of the property may also be treated as an involuntary conversion. To qualify under this rule, the converted portion of the property must be incapable of replacement, and there must be a substantial economic relationship between the condemned portion and the portion sold such that without the condemned portion the use of the remaining portion would be rendered impractical. This would be the case, for example, if a portion of one’s front or back yard was condemned, making the continued use of the residence impractical. The IRS has ruled that where a dwelling of a residence had been destroyed, the later sale of the land portion of the residence within the involuntary conversion replacement period would be treated as part as a single involuntary conversion eligible for section 1033 treatment [Revenue Ruling 96-32 (1996-1, C.B. 177)].

The coordination between the IRC section 121 exclusion and the IRC section 1033 rollover provisions is provided in IRC section 121(d)(5)(B). The amount realized from the sale or exchange of the property (i.e., the insurance or condemnation proceeds) will be reduced by the amount of the gain not included in gross income pursuant to IRC section 121. For purposes of IRC section 1034, this permits the taxpayer to retain that portion of the proceeds representing the excluded gain under IRC section 121 without reinvestment in qualifying replacement property. Upon reinvestment of the proceeds, the rollover provisions of IRC section 1033 apply by reference to the portion of the gain not excluded under IRC section 121 and for purposes of computing the adjusted basis and holding period of the replacement property (i.e., the new residence).

The following example, based on Treasury Regulation section 1.121-4(d)(4), illustrates the application of these provisions:

  • A fire destroys Taxpayer A’s house, which has an adjusted basis of $80,000. A had owned and used this property as her principal residence for 20 years prior to its destruction. A’s insurance company pays A $400,000 in settlement of the claim. A realizes a gain of $320,000 ($400,000 – $80,000). Several months later, A purchases a new house for $100,000.
  • Because the destruction of the house is treated as a sale for purposes of IRC section 121, A will exclude $250,000 of the realized gain from this deemed sale. For purposes of IRC section 1033, the amount realized is then treated as $150,000 ($400,000 – $250,000) and the gain realized is $70,000 ($150,000 – $80,000 basis). If A acquires a replacement residence for $100,000, the rollover provisions of IRC section 1033 will apply, and she will recognize only $50,000 of the gain ($150,000 – $100,000 cost). The remaining $20,000 of gain is deferred, and A’s basis in the new house is $80,000 ($100,000 cost – $20,000 deferred).
  • A will be treated as owning and using the new house as a principal residence during the 20-year period that A owned and used the destroyed house.

The involuntary conversion provisions are also relevant with regard to the availability of a reduced exclusion under IRC section 121 if the taxpayer does not meet the two-out-of-five-years residency requirement before the deemed sale. Under Treasury Regulation section 1.121-3(e)(2)(i), the taxpayer is eligible for a prorated exclusion if the two-year residency period is not met because of an involuntary conversion. For example, if a taxpayer occupied a personal residence for 18 months before the house was destroyed by fire and the received insurance proceeds resulting in a gain, the taxpayer would be eligible for an exclusion of 3/4 (18 months out of 24 months) of the $250,000 (or $500,000 in the case of married filing jointly) exclusion.

Like-kind Exchanges: IRC Section 1031

The IRS offered guidance to taxpayers that exchange properties qualifying for both the gain exclusion provisions of IRC section 121 and the deferral of gain provisions applicable to like-kind exchanges under IRC section 1031. In Revenue Procedure 2005-14 (2005-7 IRB, 1/27/2005), the IRS acknowledged the provisions in IRC section 121 that are cross-referenced with IRC section 1033 provisions dealing with involuntary conversions. Revenue Procedure 2005-14 sets forth a similar cross-referencing mechanism to coordinate the IRC section 121 gain exclusion with the IRC section 1031 deferral of gain provisions when the requirements of both sections are met.

IRC section 1031 provides that no gain or loss shall be recognized on the exchange of property held for productive use or investment if that property is exchanged for like-kind property also held for productive use or investment. The receipt of cash or other dissimilar property (boot) will cause the taxpayer to recognize gain to the extent of the fair market value of the boot or the amount of the realized gain, whichever is less. The section does not apply to property which is used solely as a principal residence; however, it will apply to a limited extent where, for example: 1) the taxpayer’s dwelling is used partly for business and partly as a residence, as where the taxpayer occupies one of the units in a multiple-family dwelling and rents out the other units or uses part of the personal residence in a trade or business; or 2) the use of the dwelling has been exclusively personal and exclusively rental in different periods, with the personal use period qualifying for the two-out-of-five-years residency requirement under IRC section 121.

Revenue Procedure 2005-14 lays out the interaction of these two sections step by step:

  • IRC section 121 is applied to the gain realized before section 1031 is applied, so that the exclusion is not lost;
  • The gain exclusion does not apply to any gain attributable to depreciation deductions for periods after May 6, 1997, but the IRC section 1031 nonrecognition treatment may apply to such gain;
  • In applying IRC section 1031, cash or boot received is taken into account only to the extent that the boot exceeds the gain excluded under IRC section 121; and
  • In the computation of basis, any gain excluded under IRC section 121 is treated as gain recognized by the taxpayer, so that an increase in basis in the property received is obtained for this excluded gain.

The application of these provisions is illustrated by an example from Revenue Procedure 2005-14:

  • Taxpayer B buys a house for $210,000 that he uses as his principal residence from 2000 to 2004. From 2004 until 2006, B rents the house to tenants and claims depreciation deductions of $20,000. In 2006, B exchanges the house for $10,000 cash and a townhouse with a fair market value of $460,000 that B intends to rent out. B realizes a gain of $280,000 on the exchange ($470,000 – $190,000 adjusted basis).
  • B’s exchange of a principal residence that he had rented for less than three years for a townhouse intended for rental use and cash satisfies the requirements of both IRC sections 121 and 1031. Section 121 does not require the property to be the taxpayer’s principal residence on the sale or exchange date. Because B owned and used the house as a principal residence for at least two years during the five-year period prior to the exchange, B may exclude gain under IRC section 121. Because the house is investment property at the time of the exchange, B may also defer gain under IRC section 1031.
  • Under section 4.02(1) of Revenue Procedure 2005-14, B applies IRC section 121 to exclude $250,000 of the $280,000 gain before applying the nonrecognition rules of IRC section 1031. B may defer the remaining gain of $30,000, including the $20,000 gain attributable to depreciation, under IRC section 1031. Although B receives $10,000 cash (boot) in the exchange, B is not required to recognize gain, because the boot is taken into account for purposes of IRC section 1031(b) only to the extent the boot exceeds the amount of excluded gain.
  • B’s basis in the replacement property is $430,000, which is equal to the basis of the relinquished property at the time of the exchange ($190,000) plus the gain excluded under IRC section 121 ($250,000), and minus the cash B receives ($10,000).
    Another illustration, again from an example in Revenue Procedure 2005-14, shows the treatment where the dwelling is mixed use, i.e., used at the same time both as a personal residence and for business.
  • Taxpayer C buys a property for $210,000. The property consists of a house that constitutes a single dwelling unit under IRC section 1.121-1(e)(2). From 2001 until 2006, C uses two-thirds of the house (by square footage) as C’s principal residence and uses one-third as an office in C’s trade or business. In 2006, C exchanges the entire property for a residence and a separate property that C intends to use as an office in C’s trade or business. The total fair market value of C’s replacement properties is $360,000. The fair market value of the replacement residence is $240,000, and the fair market value of the replacement business property is $120,000, which is equal to the fair market value of the business portion of the relinquished property. From 2001 to 2006, C claimed depreciation deductions of $30,000 for the business use. C realizes a gain of $180,000 on the exchange ($360,000 – $180,000 adjusted basis).
  • Under IRC section 121, C may exclude the gain of $100,000 allocable to the residential portion of the house [2/3 of $360,000 ($240,000) minus 2/3 of $210,000 basis ($140,000)], because C meets the ownership and use requirements for that portion of the property.
  • The remaining gain of $80,000 [1/3 of $360,000 ($120,000), minus $40,000 adjusted basis (which is 1/3 of $210,000 basis, minus $30,000 depreciation)] is allocable to the business portion of the house. Under section 4.02(1) of Revenue Procedure 2005-14, C applies IRC section 121 before applying the nonrecognition rules of IRC section 1031. Under IRC section 1.121-1(e), C may exclude $50,000 of the gain allocable to the office, because the office and residence are part of a single dwelling unit. C may not exclude that portion of the gain ($30,000) attributable to depreciation deductions, but may defer the remaining gain of $30,000 under IRC section 1031.
  • C’s basis in the replacement residential property is the fair market value of the replacement residential property at the time of the exchange ($240,000). C’s basis in the replacement business property is $90,000, which is equal to C’s basis in the relinquished business property at the time of the exchange ($40,000) plus the gain excluded under IRC section 121 attributable to the relinquished business property ($50,000). See section 4.03 of Revenue Procedure 2005-14 for more details.

William A. Bottiglieri, CPA, JD, is an assistant professor in the department of accounting at Iona College, New Rochelle, N.Y. Steven L. Kroleski, JD, is an assistant professor in the department of finance and business law, also at Iona College.


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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