1031 exchangeI just had a client come in to see me that owned a commercial rental property that he no longer wanted.  Researching his tax basis we determined that he will have a $150,000 capital gain on sale.  Instead of selling the property his realtor has suggested that he do a 1031 like-kind exchange for a residential rental property to defer the gain.  The realtor further suggests that he should only rent it out for a year or so, then move in and treat it as a personal residence.  By doing this the realtor insists that the deferred gain of $150,000 on the 1031 like-kind exchange would be excluded under Code Section 121 (non taxable gain on personal residence) as long as the client lives in the residence for two years.

I was thankful this client sought my help before diving in with inaccurate advice.  The client could certainly exchange the commercial rental for a residential rental and defer the $150,000 gain under section 1031.  In fact, a taxpayer can exchange rental property for investment property and still qualify under this code section.  That, unfortunately, is the end of the proper advice the realtor had given the client.

Section 121 (non-taxability of gain on personal residence) has been modified since adoption.  In years after December 31, 2008, any gain has to be proportioned between “qualified” and “non-qualified” use.  The percentage of time during the five year holding period that the residence was not the personal residence would give rise to taxable gain and only the percentage of the gain attributable to the time the dwelling was his personal residence will be excluded.

The rules especially state:
  1. The taxpayer must own the property for five years from the date of acquisition and he must live in it personally two of those five years.
  2. Depreciation taken during those five years (during the time it was a rental) is not excluded. It is especially important to note that the tax law states depreciation taken or eligible to be taken counts in this and all scenarios so you can never just simply not take the depreciation.
  3. The gain has to be figured and then the percentage of time the dwelling was personal residence is excluded and the time that it was a rental is taxable. For all practical purposes it needs to be your personal residence for all five years in order to exclude the gain from taxes.

Submitted by YPMA Member Richard A. “Dick” Klein, EA