A 1031 exchange lets you defer gains on the sale of rental property.
The sale of a primary residence qualifies for exclusion of 250k or 500k if married also known as 121 Exclusion.
121 Exclusion is reduced if you move into a rental property and turn it into a primary residence.
However, the reduction is on the gain, not on the exclusion itself. So if your gain is big enough, you will be able to take the full exclusion.
Can these two be combined?
Here are some scenarios.
1. Rental Property converted to Primary Residence, no 1031
In this case you are not going to do a 1031, you are just going to sell it and cash out.
You and your wife buy a rental property for $700k and rent it out for 10 years taking depreciation of $181k. then you move into the property and live in it for 2 years and sell it for $1.5mil. What exclusion do you qualify for?
You qualify for some of the 121 Exclusion…..Here is the calculation.
( 2 years of primary residence / 12 years of ownership ) * 800k gain = 133k of exclusion allowed.
You will pay Long-term Capital gains on income of 800-133 = 667k.
You will recapture the depreciation taken of $181k at 25%.
Recapture of depreciation is actually at your ordinary income rate but is capped at 25% so we’ll just use 25% in this example.
You will also have to pay 3.8% of Net Investment Income Tax (NIIT) on probably every scenario unless your income is less than 250k.
2. Was always rental…did 1031 and moved in as primary then sold
In this case you did a 1031 and moved in after 3 years of renting out the replacement property.
You and your wife buy a rental property for $700k and rent it out for 10 years taking depreciation of $181k. Did a 1031 exchange where you sold the property for $1.5 mil and bought a replacement property for $1.8mil, rented out for 3 years then you move into the property and live in it for 6 years and sell it for $2.9 mil. What exclusion do you qualify for?
You previously deferred 800k of gain and 181k of depreciation recapture when you did 1031 exchange.
The gain on the sale of the replacement property is 2.9mil – 1.8mil = 1.1mil
You qualify for 121 exclusion when you sell the replacement property that you lived in, here is calculation:
121 Exclusion = ( 6 years of primary residence / 9 years of ownership) * 1.1 mil gain = 733k, but you are limited to only $500k exclusion.
total gain = 1.1mil – 500k = 600k
You will need to pay capital gains tax on income of 600k gain + 800k of previously deferred gains = 1,400,000
And you will need to recapture the $181k at 25%.
You can’t use 121 exclusion on any depreciation recapture.
3. Primary Residence Converted To Rental Property for 2 years then sold
You and your wife buy a primary residence for $700k and live in it for 10 years. then you move out of the property and rent it out for 2 years and claim 20k of depreciation before you sell it for $1.5mil. What exclusion do you qualify for?
On the date of the sale you look back 5 years and see what you used it for
3 years were primary residence, and 2 years rental.
Since it was a primary residence before you converted to rental property, you can claim the full 121 exclusion without needing to divide the number of use over ownership.
Gain = 1.5mil – 700k = 800k
You can exclude 500k.
so you pay capital gains tax on 300k of income.
recapture the 20k of depreciation at 25%.
4. Primary Residence converted to rental property for 2 years then 1031 exchange
You and your wife buy a primary residence for $700k and live in it for 10 years. then you move out of the property and rent it out for 2 years and claim 20k of depreciation before you complete a 1031 exchange where you sell it for $1.5mil and purchase a replacement property for $1.9mil. What exclusion do you qualify for?
The 121 Exclusion applies before the 1031 exchange.
Gain = 1.5mil – 700k = 800k
Exclude 500k
Gain = 300k
Since you did a 1031 and your are able to exclude 500k, your basis in the new property is calculated like this:
Basis = 1.9mil replacement cost – 300k deferred gain = 1.6mil
Now lets say you rent the new property out for 3 years and then move in and live in it for 5 years then sell the property for 2.5mil
You would qualify for some 121 exclusion again.
2.5mil – 1.9mil = 600k
( 5 years primary residence / 8 years ownership) * 600k = 375k excluded
You would pay capital gains on 225k gain + 300k deferred gain = 525k
plus recapture the depreciation taken at 25%.
Call Moontree Tax Service (408)-475-2306 or visit our contact page if you want to get more information about how these two tax concepts relate to each other.
