Deferral to the Same Transaction
Wayne M. Schell
JUNE 2006 - IRS
Revenue Procedure 2005-14 provides guidance on applying
both IRC section 121, regarding the exclusion of gain on
the disposition of a principal residence, and section 1031,
regarding nonrecognition of gain on a like-kind exchange,
to the disposition of a single property. As home prices
escalate, many taxpayers find themselves in a position to
benefit from the simultaneous applications of both provisions.
Fortunately, the rules are relatively straightforward.
Guidance on Applying Both Provisions
4.02(1) of Revenue Procedure 2005-14 provides that when
both provisions apply, gain is excluded under section 121
before any gain deferral under section 1031. Under IRC section
121, the taxpayer may exclude up to $250,000 of gain ($500,000
on joint returns) on the sale or exchange of property if
it was owned and used as the taxpayer’s principal
residence for at least two years out of the five-year period
ending on the date of the disposition. Under IRC section
121(d)(6), however, gain that is attributable to depreciation
deducted after May 6, 1997, is not eligible for the exclusion.
additional restriction applies where property is partly
used as a residence and partly held for productive use (business
or investment), and the productive-use part of the property
is not located in the same dwelling unit as the residence.
In that situation, section 2.03 of Revenue Procedure 2005-14
provides that the gain attributable to the productive-use
part of the property is not eligible for the exclusion unless
it also passes the two-year-use test. If the productive-use
and residential portions of the property are separate but
within the same dwelling unit, the gain attributable to
the productive-use part of the property is eligible for
the exclusion. To determine the amount of gain assigned
to the productive-use and residential parts of the property,
section 2.04 of Revenue Procedure 2005-14 provides that
the taxpayer must allocate basis and amount realized using
the same method used for assigning depreciation to the property.
The IRS considers square footage to be an appropriate basis
the residential part of the property, any gain in excess
of the section 121 exclusion is taxable. On the productive-use
part of the property, however, the gain in excess of the
section 121 exclusion may be eligible for deferral under
IRC section 1031. Section 1031(a) provides that when productive-use
property is exchanged solely for like-kind property, no
gain or loss is recognized on the exchange. Section 1031(b),
however, provides that if any cash or non–like-kind
property is received in the same transaction, the taxpayer
must recognize the gain to the extent of the “boot”
(cash or other dissimilar property) received. Under section
4.02(3) of Revenue Procedure 2005-14, boot is considered
taxable on the productive-use part of the property only
to the extent that the boot exceeds the gain excluded under
IRC section 121.
part, IRC section 1031(d) provides that the basis of property
received in a like-kind exchange shall be the same as that
of the property exchanged, decreased by any boot received
and increased by any gain recognized. Under section 4.03
of the Revenue Procedure, when IRC sections 121 and 1031
are both applied, the gain excluded under section 121 is
treated as gain recognized for purposes of computing the
basis of the replacement property.
Procedure 2005-14 envisions three alternative property-use
combinations where both provisions can apply. In one, a
principal residence is fully converted to productive-use
property prior to disposition. In the second, the property
is used partly as principal residence and partly for productive
use, with the productive-use part located in a separate
structure. The third is like the second, except that the
residence and the productive-use property are located in
the same dwelling unit. The following examples correspond
to the three possibilities.
1). In 2001, single taxpayer Q bought
a house for $100,000. The house was used as Q’s principal
residence until 2004, when it was converted to rental property.
After taking $10,000 in depreciation, Q disposes of the
house in 2006, and under a section 1031 tax-deferred exchange
acquires other real estate to be used as rental property.
In situation A, Q receives a house worth $300,000, and $15,000
in cash. In situation B, Q receives a house worth $80,000,
and $315,000 in cash. In situation C, Q receives a house
worth $110,000, and $315,000 in cash.
situation A, Q realizes a gain of $225,000. Nonetheless,
only $215,000 of the gain can be excluded under section
121, because $10,000 of the gain is attributable to depreciation
deductions on the original property. That gain, however,
can be deferred under section 1031 because the $15,000 cash
received in the transaction did not exceed the $215,000
of section 121 gain excluded. The basis of the new property
($290,000) is equal to the basis
of the property exchanged ($90,000) plus the gain excluded
($215,000) and minus the boot received ($15,000).
situation B, Q realizes a gain of $305,000. As a result,
$250,000 may be excluded under section 121. Because the
$315,000 cash (boot) received exceeds the section 121 gain
excluded by $65,000, the remaining realized gain of $55,000
(including $10,000 attributable to depreciation taken) must
be recognized; no section 1031 tax deferral can be taken.
The basis of the new property is $80,000.
situation C, Q realizes a $335,000 gain. The maximum $250,000
exclusion is allowable. Of the remaining gain of $85,000,
$65,000 is taxable to the extent the $315,00 in boot exceeds
the gain excluded. That leaves $20,000 of gain that can
be deferred under section 1031. The basis of the new property
is then $90,000.
2). In 2001, single taxpayer R paid $180,000
for property containing a house and a guesthouse. $135,000
of the cost is attributable to the house, and $45,000 is
attributable to the guesthouse, a 3:1 ratio. The guesthouse
is used as rental property, and $15,000 of depreciation
is taken prior to disposition. In 2006, R disposes of the
entire property in a tax-deferred exchange, for $20,000
and two other properties that will replace the residence
and the rental property. The new residence is valued at
$300,000, and the new rental property is worth $80,000.
In situation D, R used the guesthouse as part of the residence
until 2004, when it was converted to rental property. In
situation E, the guesthouse has been used as rental property
both situations D and E, R realizes a gain of $235,000.
In situation D, the part of the property used as rental
property independently passes the use test of section 121.
As a result, the gains on both the residential and the rental
parts of the property qualify for the section 121 exclusion.
The entire gain, except for the $15,000 attributable to
depreciation, is excludable. This $15,000 of nonexcludable
gain may, however, be deferred under section 1031. The $20,000
in boot received is not recognized gain because it does
not exceed the section 121 excluded gain. The basis of the
new residence is $300,000, and the basis of the new rental
property is $65,000.
situation E, R is not eligible for exclusion of gain on
disposition of the guesthouse, because that structure does
not satisfy the use test. Only the $165,000 gain on the
residence may be excluded. The gain on the disposition of
the guesthouse, however, continues to be eligible for deferral
under section 1031. Because the boot received was attributable
to the guesthouse, $20,000 of the $70,000 guesthouse gain
must be recognized, and $50,000 can be deferred. The basis
of the new residence is $300,000, and the basis of the new
rental property is $30,000.
3). In 2001, single taxpayer S buys a
property for $180,000. It consists of a single dwelling
unit, 75% of which is a principal residence; the balance
is devoted to business activities. Depreciation of $15,000
is taken against the business part of the property, and
in 2006 the property is disposed of in a tax-deferred exchange
for two replacement properties. Because there is a single
structure (dwelling unit), the business part of the property
does not need to independently pass the use test. If the
residential part of the property meets the use test, that
is sufficient. Therefore, gain (other than that attributable
to depreciation taken after May 6, 1997) of up to $250,000
on the disposition of the property is excludable, regardless
of whether it is attributable to the residential or the
business part of the property.
situation F, the property is transferred under a section
1031 exchange for $30,000 and two other pieces of property:
a residence valued at $370,000, and business property worth
$100,000. The amount realized is allocated between the residence
and the business part of the property in a 3:1 ratio. The
total gain is $335,000, with $240,000 assigned to the residential
part of the property and $95,000 assigned to the business
part. The entire gain attributable to the residence is excludable
under section 121, as is $10,000 of the gain on the business
part of the property, i.e., the balance of the section 121
exclusion. Because the $25,000 boot received in the exchange
for the business property exceeds the $10,000 gain excluded,
the excess $15,000 must be recognized, leaving $70,000 of
gain that can be deferred. The basis of the new residence
is $370,000, and the basis of the new business property
situation G, the same property is disposed of in a section
1031 exchange for $30,000 in cash, a residence worth $440,000,
and business property with a fair market value of $130,000.
Again, the total amount realized is allocated between the
residential and the business parts of the property in a
3:1 ratio, resulting in realized gains of $315,000 and $120,000,
respectively. The full $250,000 exclusion is applied to
the gain on the residential part of the property, leaving
a $65,000 gain to be recognized. The gain on the business
part of the property must be recognized to the extent of
the $20,000 boot received, and the remaining $100,000 can
be deferred. The basis of the new residence is $440,000,
and the basis of the new business property is $30,000.
M. Schell, PhD, CPA, is an associate professor of
accounting at Christopher Newport University, Newport News,