To remove your email from the subscriber's list, please follow the instructions at the end of the email notification.

Issue # 19 January, 2005

In This Issue:
Exchanging into a Residence
Converting a Residence Then Exchanging It
Sec. 1031 Deadline Extensions
Requirements for Postponement

Combining the Residency Exclusion with Tax-Free Exchanges

Introduction Several recent developments have significantly impacted the combination of the principal residence exclusion rules (IRC Sec. 121) with the like-kind tax-free exchange rules (IRC Sec. 1031).

Under IRC Sec. 121, in general, gain to a maximum of $250,000 ($500,000 for joint filers) is excluded when a taxpayer sells a principal residence, provided the taxpayer owned and lived in the residence for at least 24 of the 60-month period prior to sale. The residence exclusion rules may be used no more than once every two years.

Under IRC Sec. 1031, a taxpayer may exchange property held for investment (or in a trade or business) for like-kind property which the taxpayer continues to hold for investment. For example, a taxpayer may exchange an apartment building for a single family dwelling, provided the acquired property is used for investment. A residence, however, is not considered investment property and cannot be exchanged tax-free under IRC Sec. 1031.

Exchanging into a Residence

First the bad news. Many taxpayers have used Sec. 1031 to acquire a potential residence (usually renting it out for the first year to comply with the like-kind exchange requirements) then living in the property as their principal residence for two years. These taxpayers then sold the property and used the residence exclusion to eliminate some or all of the gain.

Congress said no to this ploy by prohibiting taxpayers from excluding any gain on the sale of a principal residence if they sold the property after Oct. 22, 2004, and acquired it in a like-kind exchange during the five-year period ending on the date of the sale.

Converting a Residence Then Exchanging It

Now the good news: IRS just announced that if a taxpayer: (i) owns and lives in a residence for at least 24 months; (ii) rents the residence out, thus converting it to investment property; and (iii) then exchanges the property for like-kind investment property, the residency rules will apply to any cash received in the exchange. In Revenue Procedure 2005-14, IRS provides the following example:

Skip buys a house for $210,000 that he uses as his principal residence from 2000 to 2004. From 2004 until 2006, Skip rents the house to tenants and claims depreciation deductions of $20,000. In 2006, Skip exchanges the house for $10,000 of cash and an investment townhouse with a fair market value of $460,000. Skip realizes a gain of $280,000 on the exchange ($460,000 -($210,000 - $20,000 depreciation) + $10,000 cash = $280,000).

The exchange by Skip of the residence (which is now rental property) for cash of $10,000 and a townhouse which he intends to use for rental satisfies the requirements of both the residency exclusion and IRC Sec. 1031. Skip may defer the remaining gain of $30,000, including the $20,000 gain attributable to depreciation, under IRC Sec. 1031. Although he received $10,000 of cash (boot) in the exchange, the residency exclusion exempts the gain from taxation.

Sec. 1031 Deadline Extensions

The IRS has allowed a blanket automatic 120-day extension for meeting like-kind exchange deadlines due to a presidentially-declared disaster or all acts that may be performed on or after January 26, 2004.

Requirements for Postponement

To qualify for the extension, the disaster must affect the tax-free exchange in any of the following ways: (1) the replacement or relinquished property is located in a disaster area; (2) the principal place of business of any party is located in a disaster area; (3) a party is missing, killed or injured as a result of the disaster; (4) a document prepared in connection with the exchange is lost or damaged; (5) a lender withdraws due to the disaster; or (6) a title company is unable to provide title insurance due to the disaster.

Tax relief is also available for identified replacement or relinquished property substantially damaged by a qualifying disaster. There is also an extension available for individuals serving in a combat zone or the armed forces.

Home |  Who We Are |  What's New |  Search |  Contact Us |  Subscribe

[Wealth Preservation]   [Employee Stock Options]   [Foreign Taxpayers]   [Tax & Trust Scams]   [Expert Witness]   [General Tax Information]
All contents copyright 1995-2004 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.