Overview of Combining a 1031 Exchange with a Section 121 Exclusion

When structured correctly, combining a 1031 exchange with a Section 121 exclusion can be one of the most powerful tax planning strategies available to property owners. This approach allows taxpayers to maximize deferral and exclusion opportunities under the Internal Revenue Code (IRC). Below is an overview of how these provisions interact, along with the key IRS rulings and legislative acts that govern them.

Legislative Acts and IRS Rulings

Congress has enacted legislation affecting how the Section 121 exclusion applies when property has also been used for investment purposes:

• American Jobs Creation Act of 2004 – Amended Section 121, requiring certain holding periods when property acquired through a 1031 exchange is later converted into a primary residence.

• Housing and Economic Recovery Act of 2008 – Added restrictions that limit the portion of gain eligible for the Section 121 exclusion if the property had nonqualified use (time spent as investment property) after January 1, 2009.

The IRS has also provided guidance through:

• Revenue Procedure 2005-14 – Outlined how taxpayers can apply both Section 121 and Section 1031 to the same transaction.

• Revenue Procedure 2008-16 – Clarified safe harbor rules for vacation homes converted into rental property before a 1031 exchange.

Section 1031 Exchange — Investment Property

Under IRC Section 1031, property held for investment or productive use in a trade or business may be exchanged for like-kind property, deferring recognition of capital gains and depreciation recapture.

Key points:

• Qualifies only for real property held for investment or business use.

• Does not apply to personal-use property such as primary residences, second homes, or vacation homes (except under limited circumstances defined in Rev. Proc. 2008-16).

Section 121 Exclusion — Primary Residence

Under IRC Section 121, taxpayers may exclude up to $250,000 of gain ($500,000 for married couples filing jointly) on the sale of a primary residence if they:

• Owned and used the property as their primary residence for at least 2 out of the last 5 years before the sale.

• Meet certain ownership and use requirements.

Important limitations:

• Only applies to a primary residence.

• Does not exclude depreciation recapture, which is always taxable.

• Amount of excludable gain may be reduced if the property had periods of nonqualified use (e.g., rental use after 2009).

Combining Sections 1031 and 121

With careful planning, taxpayers may combine these provisions. Three common scenarios illustrate how this works:

1. Rental Property Converted to Primary Residence (No Prior 1031 Exchange)

• Property originally purchased as investment real estate is later converted into a primary residence.

• After living in it for at least 24 months, the taxpayer may qualify for the Section 121 exclusion.

• Only a portion of gain may be excluded, since investment use is factored in (with exceptions for pre-2009 usage).

2. Rental Property Converted to Primary Residence (Prior 1031 Exchange)

• Property was first acquired through a 1031 exchange, then converted to a primary residence.

• IRS requires ownership for at least 5 years before the Section 121 exclusion may apply.

• Taxpayer must also live in it for at least 24 months as a primary residence within that period.

• Gain exclusion is prorated, with investment use after 2009 considered nonqualified.

3. Primary Residence Converted to Rental Property

• A taxpayer with a highly appreciated primary residence may convert it to a rental property.

• Holding it as investment property for at least 12 months or more (with no personal use) can help demonstrate intent to qualify under Section 1031.

• Upon sale, the taxpayer may:

  • Exclude up to $250,000 / $500,000 under Section 121.

  • Use a 1031 exchange to defer the remaining gain into other investment property.

Key Takeaways

• Section 121 exclusion applies to primary residences.

• Section 1031 exchange applies to real property held for investment or business.

• With proper planning, both provisions may be used together, allowing partial exclusion and deferral.

• IRS holding periods and ownership requirements must be carefully observed.

• Depreciation recapture cannot be excluded under Section 121 and must be recognized when the property is sold.

Disclaimer: This overview is for educational purposes only and is based on the Internal Revenue Code, legislative acts, and IRS guidance. Taxpayers should consult with qualified tax and legal advisors before