Exchange Deferral to the Same Transaction

By Wayne M. Schell

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IRS Guidance on Applying Both Provisions

Section 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.

An 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 for allocation.

On 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.

In 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.

Three Scenarios

Revenue 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.

Example 1 (Exhibit 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.

In 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).

In 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.

In 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.

Example 2 (Exhibit 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 since 2001.

In 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.

In 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.

Example 3 (Exhibit 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.

In 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 is $30,000.

In 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.