A common question from our clients is whether they can do a §1031 exchange when they sell their primary residence. The off-the-cuff answer is no. Internal Revenue Code §1031 only applies to properties that are “held for productive use in a trade or business or for investment.” While a residence may be a very good investment, its primary use is typically the use and enjoyment of the owner and their family rather than making money when it is sold. Accordingly, a primary residence typically would not be eligible for a §1031 exchange.

In these situations, we direct our clients to Internal Revenue Code §121. It allows homeowners to exclude up to $250,000 of gain as a single person, or $500,000 as a married couple filing jointly, provided the property was owned and occupied as the taxpayer’s primary residence for two of the five years prior to the sale.

This exclusion has been a huge benefit for homeowners. When the law passed in 1997, only the sellers of the very highest-priced properties faced taxes on the sale. Unfortunately, the exclusion amounts were not indexed for inflation, and as real property values have increased dramatically, many homeowners today find that their gains exceed these thresholds and that the excess is subject to taxation.

When both benefits apply

There are several scenarios where a homeowner can have their cake and eat it too. In 2005, the IRS issued Revenue Procedure 2005-14, which allows taxpayers to benefit from both IRC §121 and IRC §1031 when the circumstances warrant. Often referred to as “split treatment” transactions, Rev. Proc. 2005-14 applies when:

  1. The property usage is physically split. A portion of the property is used as a primary residence and a portion is used for productive use in a trade or business or for investment. The homeowner is entitled to the §121 exclusion on the residential portion and can defer the gain on the business or investment portion by exchanging for a like-kind replacement property under §1031. This would apply to a multi-family property in which the homeowner lives in one of several units, an Airbnb property where part of the residence is used exclusively for short-term rentals, or a farm where part of the property is the owner’s residence and the remaining acreage is used for commercial agriculture.
  2. The property usage is split by time. A property is used as a primary residence for at least two years and then converted to a rental or other business use for up to three years. A homeowner whose property has appreciated well beyond the §121 exclusion can move out and rent it for a period of time (many advisors suggest two years minimum, but no longer than three) before selling. Because the property was their primary residence for two of the five years prior to sale, they are entitled to the §121 exclusion. Because it was used for business or investment in the years immediately preceding the sale, they may defer taxes on the remainder of the gain by including the balance of the sales price in a §1031 exchange and acquiring a like-kind replacement property.

Considerations

The split treatment benefits of Rev. Proc. 2005-14 are not available for vacation homes and second homes that are not the homeowner’s primary residence. However, a §1031 exchange still may be possible for those properties. See our article on vacation home exchanges, which discusses Rev. Proc. 2008-16.

Homeowners should also discuss with their advisors whether and how §121 applies to their property, as well as how the sales price of a physically split property should be allocated between the residential and the investment use.