TAX SAVING POTENTIAL FOR PROPERTY WITH OVERLAPPING RESIDENTIAL AND BUSINESS USES (9/6/2005)
Most homeowners are aware of the tax savings on the sale of a principal residence provided by Internal Revenue Code Section 121. Generally, if a property has been used as a principal residence for at least two of the five years preceding the sale, $250,000 ($500,000 for a married couple) of capital gain from the sale is exempt from taxation, except for any depreciation taken on the property since May 6, 1997. Many people are also aware of the potential tax benefits of an IRC Section 1031 like-kind exchange. Section 1031 provides that no gain is recognized on the exchange of business or investment property, if it is exchanged solely for replacement property to be held for business or investment purposes. The interaction between Sections 121 and 1031 has been clarified by the IRS in Revenue Procedure 2005-14.
Issued on February 14, 2005, the Revenue Procedure addresses the confusion that may arise when certain property qualifies for treatment under both Section 1031 and Section 121. It “applies to taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the exchange of a principal residence under Section 121 and the non-recognition of gain on the exchange of like-kind properties under Section 1031.” Since neither Section addresses the application of both Sections to the exchange of a single piece of property, the Revenue Procedure addresses transactions where the two Sections overlap; for example, when a taxpayer uses the property as a principal residence for two years, then converts it to a rental property for the next two years and sells the property in year five. At the end of the first four years in the example, the property would qualify for treatment under both Sections.
Prior to the new guidance, the taxpayer would need to choose which Section to apply in such an overlap scenario. Revenue Procedure 2005-14 permits the taxpayer to use both Sections by first applying the $250,000 tax exclusion available under Section 121 and then deferring any tax due on any remaining gain pursuant to Section 1031. This ruling is particularly beneficial to a homeowner who has accumulated more than $250,000 of capital gain on a principal residence and is interested in converting the residence to an investment property for the purpose of deferring taxation of the portion of capital gains which exceeds that amount.
In the reverse scenario, where an investment property was acquired through a Section 1031 exchange and later converted to the taxpayer’s principal residence, the IRC provides that before Section 121 can be applied, the property must not only be the taxpayer’s principal residence for two years, but also be owned for at least five years.
The Revenue Procedure also addresses the sale of a property containing both a primary residence and a separate building used for investment or business purposes. In this situation neither the residence nor the separate building would qualify for treatment under both Section 121 and Section 1031. The Revenue Procedure provides that the gain on the sale of the residence could be excluded under Section 121, while the gain on the separate building could be deferred if the building were exchanged for replacement business property. In other words, any sale of the entire property would be treated as two separate transactions.
Finally, the Revenue Procedure addresses the situation where a taxpayer uses a portion of his or her principal residence as a business office. It provides that the taxpayer could exchange the property and apply the $250,000 exclusion available under Section 121 to any gain (including the portion of any gain realized in cash or taxable “boot”). Note, however, that the portion of any gain attributable to depreciation deductions taken since May 6, 1997 would not be excludable under Section 121, but could be deferred under Section 1031, and that any gain in excess of $250,000 that is applicable to the principal residence portion of the property is neither excludable under Section 121 nor deferrable under Section 1031.
While the IRS has provided considerable guidance and increased potential tax savings for qualifying taxpayers, the technical tax considerations for each situation should be closely evaluated by an attorney or an independent tax advisor.
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