Combining Sections 1031 and 121 on the Sale or Exchange of Real Estate
When selling real estate, U.S. taxpayers may be eligible for capital gains tax relief under two powerful provisions of the Internal Revenue Code:
Section 121 (Primary Residence Exclusion) – Allows homeowners to exclude up to $250,000 of gain ($500,000 if married filing jointly) from the sale of a primary residence, if ownership and use requirements are met.
Section 1031 (Like-Kind Exchange) – Allows investors to defer taxes by reinvesting proceeds from investment or business real estate into other like-kind property.
In some situations, taxpayers can combine these benefits—using Section 121 to exclude gain related to a personal residence and Section 1031 to defer gain related to investment use of the same property.
When Both Sections Apply
Many properties serve a dual purpose over time:
A personal residence that is later converted into a rental.
A rental or vacation home that becomes a primary residence.
A mixed-use property with both residence and rental units.
In these cases, a taxpayer may qualify for both Section 121 and Section 1031 treatment on the disposition of the property.
How the Combination Works
Section 121 Exclusion Applies First
The homeowner may exclude up to $250,000 ($500,000 married filing jointly) of gain attributable to the residence portion, provided they have lived in the property for two of the last five years before the sale.
Remaining Gain May Qualify for Section 1031
Any additional gain tied to investment or business use of the property may be deferred through a 1031 Exchange, provided replacement property is acquired and IRS rules are followed.
Example
A married couple buys a home for $400,000.
They live in it for 3 years, then rent it out for 4 years.
They sell the property for $900,000.
Total gain = $500,000.
Result:
Section 121 Exclusion: $500,000 gain exclusion available for married couples, but reduced for “nonqualified use” (post-2008 rental years). Suppose $300,000 qualifies for exclusion.
Section 1031 Exchange: The remaining $200,000 of gain, tied to rental use, can be deferred into a new like-kind property through a 1031 Exchange.
Key IRS Guidance
Revenue Procedure 2005-14 provides detailed instructions on how Sections 121 and 1031 can be applied in combination.
Housing and Economic Recovery Act of 2008 (HERA) modified Section 121 to limit exclusions for periods of “nonqualified use” (e.g., rental use after 2008).
Important Considerations
Allocation of Gain – Taxpayers must carefully allocate between personal and investment use.
Depreciation Recapture – Depreciation taken during rental periods cannot be excluded under Section 121 and will be recaptured as ordinary income.
Strict Timelines – For the 1031 portion, all IRS rules (45-day identification, 180-day closing) must be met.
Planning Ahead – The order of transactions and timing of personal vs. investment use can greatly impact the tax outcome.
Sections 121 and 1031 can work together to provide significant tax relief when selling or exchanging real estate with both personal and investment components. Section 121 allows homeowners to exclude gain from genuine personal residence use, while Section 1031 enables continued tax deferral on the investment portion.
Because the rules are highly technical, particularly around nonqualified use and depreciation recapture, taxpayers should consult with qualified tax advisors well before a sale to structure the transaction for maximum benefit.
