Combining Section 121 and 1031
Section 121 of the Internal Revenue Code is the best of all IRS Tax Code sections for the regular taxpayer.
Section 1031 is the best for the real estate investor.
Together, Section 121 and Section 1031 could be used to completely eliminate Capital Gains taxes in many situations, and could be used to defer those taxes indefinitely in other situations.
Section 121 allows the taxpayer to eliminate Capital Gains taxes on the sale of a personal residence lived in for two out of five years.
If you need a refresher on Capital Gains and Depreciation Recapture, you can find it elsewhere on this site.
The rules for doing a Section 1031 Exchange can also be found elsewhere on this site.
There are four scenarios where Section 121 and Section 1031 can come together to benefit the real estate investor.
I will cover each one separately.
Section 121 + Section 1031
Mixed Use
Sometimes your investment real estate will not be entirely investment real estate. It might also have a residence involved, and the residence might be your “primary residence” as that term is defined in Section 121.
This is called “Mixed Use” by the IRS.
An Example would be a 100-acre farm.
It might contain 95 acres of farm land, and then the house and 5 acres.
The farm is the business that comes under Section 1031, and the house is the personal residence that comes under Section 121.
Another Example would be a motel.
A motel might contain the office, lounge, laundry, and rental units, and then contain a separate living unit which is the owner’s residence.
The residence doesn’t even have to be physically separate, as long as it can be dealt with separately as far as the numbers are concerned.
If you are involved in a situation like this, you will want to allocate as much of the property value as possible to the personal residence category, and take advantage of the Section 121 exemption, because all of that Capital Gains could be completely tax-free.
Then you can do a Section 1031 Exchange with the remainder of the property, and defer the taxes on the Capital Gains and the Depreciation Recapture by purchasing a like kind investment property.
Section 121 Residence to Rental
The best of the four combinations of Section 121 and Section 1031 is where you purchase a house as your primary residence and live in it for two years, qualifying for the Capital Gains tax exemption of up to $250,000 for a single taxpayer and $500,000 for a married taxpayer available under Section 121.
Remember, the qualification says that you owned the property and lived in it as your primary residence for two years out of the five years prior to the sale.
That is the key to this strategy.
It means that you don’t have to sell the property when you move out in order to use Section 121.
You can now use it as a rental property for three years, and still claim the exemption from Capital Gains taxes for the entire five-year period.
This exclusion from Capital Gains taxes includes the Capital Gains that accrued during the three-year period that you were using the property as rental investment property, and while it was increasing in value.
If you sell the property just prior to the expiration of the five-year period, you can claim the Section 121 Primary Residence exclusion on all of the Capital Gains, not just the amount that accrued while you were living in it.
Your only tax liability will be a 25% tax called a Depreciation Recapture tax, figured on the amount of depreciation that you claimed during the three years that the property was a rental investment property.
Let’s use an Example.
Assume that you purchased a $350,000 residence, lived in it for two years, rented it out for three years, and sold it for $484,050 just prior to the expiration of the five-year period. This assumes an annual 6.7% increase in value.
What are your numbers?
Your Capital Gains after two years is $48,471 and this would be exempt from taxation if you sold at this point. But you rented it for three years.
Then you sold it for $484,050.
You claimed $38,182 in depreciation during the three years of rental.
So, your Capital Gains after five years is $134,050 of true Capital Gains, and $38,182 of Capital Gains attributable to the reduction in Basis caused by the depreciation.
The $134,050 of true Capital Gains would all be exempt from taxation under Section 121.
Your Depreciation Recapture tax of 25% on the $38,182 would amount to $9,545, and this would be your only tax.
By the way, this $9,545 is probably close to the amount of income tax that you saved by claiming the depreciation in the first place, so it is really a wash.
Your Section 121 exemption would eliminate the $20,108 of Capital Gains tax that the $134,050 of profit would normally trigger, assuming that you were in the 15% Capital Gains tax bracket.
And there is even a way that you can sell the property to yourself, and continue with your current tenant and cash flow, while taking out all of your profit.
Rental to Section 121 Residence
You don’t have to go out and buy a primary residence in order to use Section 121 and Section 1031 together to exempt or defer taxes.
Assume the same circumstances as above, except that when you bought the $350,000 property you immediately began using it as a rental real estate investment, and continued for almost three years.
Then, you moved into it, and used it as your primary residence for two years.
If you now sell the property for $484,050, what are your numbers?
The math is a bit different from the previous Example.
Your true Capital Gains, the difference between what you paid for the property and what you sold it for, is $134,050.
The IRS assumes, and requires you to also assume, that the amount of Capital Gains accruing was an equal amount each year.
$134,050 divided by five years is $26,810 per year.
You owned and lived in the property as your primary residence for two of the five years, so you can exempt two-fifths, or 40% of the Capital Gains, a total of $53,620.
The remaining $80,430 of Capital Gains is taxable at your personal Capital Gains rate, which we are assuming to be a total of 15%.
Also taxable is the $38,182 of Depreciation Recapture at 25%.
You would pay $12,065 tax on the $80,430 of Capital Gains.
You would pay $9,545 tax on the Depreciation Recapture.
Your total taxes would be $21,610.
This assumes that you don’t do a Section 1031 Exchange to defer these taxes.
This compares to paying $9,545 for doing the same thing, only in reverse order.
One more thing.
In order to do this 121 + 1031 combination, you must make sure that when you bought the property, you bought it either in your name, or in the name of a Limited Liability Company (LLC) which is treated as a disregarded entity for tax purposes.
This satisfies the Section 121 requirement that you actually owned the property during the five years that you were living in it for Section 121 qualification.
Section 1031 to Section 121
Assume the same scenario as above, but with one critical difference.
When you acquired the property, you did so in a Section 1031 Exchange, and the property was your Replacement Property.
In 2004, the IRS added the requirement for this scenario that you must own the property for at least five years, along with the other qualifications, in order to use Section 121.
However, I cannot tell you what your numbers would be under this scenario.
Depreciation, Basis, Capital Gains, Section 121 exclusion amount, Depreciation Recapture amount, etc., would all depend on the carryover amounts from the Relinquished when you purchased this property as your Replacement Property.
It’s complicated. But it can be done. I just don’t have any numbers to work with.
Section 121 Conclusion
There is actually another scenario where Section 121 and Section 1031 come together to benefit the real estate investor.
That situation is where you purchase a Duplex or a Fourplex and live in one of the units while renting out the others. It is another type of the Mixed Use discussed at the beginning of the Chapter.
But it is a discussion for another time.
I urge you to learn about Section 121 and how to use it in conjunction with Section 1031.
If you are a real estate investor, it is the very best combination of wealth strategies available, and a very strong technique to add to your lifetime investing plan.