SECTION 121 + 1031

Section 121 is the best of all IRS Tax Code sections for the regular taxpayer, Section 1031 the best for the real estate investor.

Together, Section 121 and Section 1031 can be used to completely eliminate Capital Gains taxes in many situations, and can be used to defer those taxes indefinitely in other situations.

If you need to review Capital Gains and Depreciation Recapture, go to Capital Gains Tax.

The rules for doing an Exchange are at 1031 Exchange Rules.

There are four scenarios where Section 121 and Section 1031 can come together to benefit the real estate investor.


Sometimes your investment real estate will not be entirely investment real estate.  It might have a residence involved, and the residence might be your “primary residence” as that term is used in Section 121.

This is called “Mixed Use” as that term is used 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.

If you come across a word or term that you don’t understand, visit our Dictionary.


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 $500,000 for a married taxpayer and $250,000 for a single 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 Depreciation Recapture tax, up to 25% depending on your marginal tax bracket for Ordinary Income, 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 $514,265 just prior to the expiration of the five-year period.  This assumes an annual 8% increase in value.

What are your numbers?

Your Capital Gains after two years is $58,250 and this would be exempt from taxation if you sold at that point.  But you rented it for three years.

You claimed $38,182 in depreciation during the three years of rental.

So, your Capital Gains after five years is $164,250 of true Capital Gains, and $38,182 of Capital Gains attributable to the reduction in Basis caused by the depreciation.

The $164,250 of true Capital Gains would all be exempt from taxation under Section 121.

Your Depreciation Recapture tax of 25% (we are assuming the maximum) on the $38,182 would $9,545, and this would be your only tax.

Your Section 121 exemption would eliminate $32,850 of Capital Gains tax.

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.

I cover that technique elsewhere on the site.


I hope you are enjoying this free content.

The remainder of this content, plus additional content, is available in my book “How To Do A Section 1031 Like Kind Exchange: Simultaneous, Delayed, Reverse, Construction” available at Amazon.com/dp/B01MY433L6.

And if you are dealing with a Triple Net Lease, Delaware Statutory Trust, or a Tenancy-In-Common property, you need the OMNIBUS EDITION at Amazon.com/dp/B07BJLZNZN.

Or you can see all ten of my books on Real Estate Investing at Amazon.com/author/michaellantrip.

And I am re-writing all of this content for use on my Blog at MichaelLantrip.com, where it has already started appearing.