A taxpayer generally may exclude up to $250,000 ($500,000 for certain married couples filing joint returns) of gain realized on the sale or exchange of a principal residence. To be eligible for the exclusion, the taxpayer must have owned the residence and used it as a principal residence for at least two years during the five-year period ending on the date of the sale or exchange.
Under the like-kind exchange rules of Internal Revenue Code §1031, a taxpayer defers recognition of gain on the exchange of property held for productive use or investment for like-kind property. Thus, a taxpayer defers a gain realized on a like-kind exchange until the disposition of the property received in the exchange. Also, the taxpayer generally has the same basis in the property received as in the exchanged property.
The like-kind exchange deferral-of-gain rules do not apply to the exchange of a principal residence, since a principal residence is not held for productive use or investment. However, it would be possible to exchange properties that do qualify as a like-kind exchange, e.g., rental properties, and then convert the property received to a principal residence, as long as the acquiring taxpayer did not intend to use it as a principal residence at the time of the exchange.
Before the American Jobs Creation Act of 2004, there were no special rules relating to the sale or exchange of a principal residence that was acquired in a like-kind exchange within the last five years.
The Jobs Act provides that the exclusion of gain otherwise allowable on the sale or exchange of a principal residence acquired in a like-kind exchange (i.e., property received in a like-kind exchange and converted to a principal residence after the exchange) does not apply to a sale or exchange after Oct. 22, 2004, if it occurs during the five-year period beginning with the date of the acquisition of the property.
Thus, a taxpayer may not shelter all or part of the deferred gain on the property exchanged in a like-kind exchange by converting the property received in the exchange to a principal residence and selling it less than five years after it was acquired.
Example 1: On March 15, 2000, your client, a single taxpayer, acquired a house to be used as rental property in a like-kind exchange. Your client rented the house to an unrelated person from the date it was acquired until Sept. 15, 2002, when she moved into the house and used it as her principal residence. On Oct. 1, 2004, after she had used the house as her principal residence for more than two years, she sold the house at a gain of $270,000. She could exclude $250,000 of the gain on the sale from her gross income, since she had both owned and used the house as her principal residence for at least two years in the five-year period before the sale, and she did not sell it after Oct. 22, 2004.
Example 2: The same facts apply as in Example 1, except that your client doesn't sell the house until Oct. 25, 2004. She cannot exclude any part of the gain on the sale, since the sale occurred after Oct. 22, 2004, and she sold the house in the five-year period beginning on the date that the house was acquired in a like-kind exchange.
Observation: The five-year holding period after the like-kind exchange begins on the date of the acquisition of the property. In a like-kind exchange where the taxpayer has up to 45 days to identify the property to be received in the exchange, and up to 180 days to acquire that property, the Internal Revenue Service may need to clarify whether the five-year holding period begins on the date that the title to the property is actually transferred to the taxpayer or on the date that the taxpayer enters into a binding contract to acquire the property.
There is a reduced home sale exclusion that is available for taxpayers who do not meet the two-year ownership and use requirements because of a change in place of employment, health, or unforeseen circumstances. However, the Jobs Act doesn't provide any exceptions to the rule that no home sale exclusion is available if a principal residence is sold during the five-year period beginning with the date the residence was acquired in a like-kind exchange.
Example 3: On July 1, 2001, your client, a single taxpayer, acquired a condominium to be used as rental property in a like-kind exchange. Your client rented the condominium to an unrelated person from the date it was acquired until Aug. 15, 2003, when he moved into the condominium and used it as his principal residence. On Oct. 15, 2004, after he had used the condominium as his principal residence for 13 months, he sold it at a taxable gain of $300,000. Your client sold the condominium because he had to move to another state due to a change in his place of employment. He can exclude $135,417 of his gain (13/24 of $250,000), since he had used the condominium for 13 months as his principal residence, the sale occurred because of a change in place of employment, and the sale did not occur after Oct. 22, 2004.
Example 4: The same facts apply as in Example 3, except that the sale took place on Nov. 1, 2004. Your client could not exclude any part of his gain, since the sale occurred during the five-year period beginning on the date he acquired the condominium in a like-kind exchange.
Example 5: The same facts apply as in Example 4, except that your client acquired the condominium in a like-kind exchange on July 1, 1999. He can exclude $135,417 of his gain (13/24 of $250,000) since he had used the condo for 13 months as his principal residence, the sale occurred due of a change in place of employment, and did not occur in the five-year period beginning with the date the condominium was acquired in a like-kind exchange.
Observation: Suppose a taxpayer acquires property that could be used as a residence in a like-kind exchange, and there is a possibility that they may convert that property into a principal residence and then sell it before the expiration of the five-year holding period. Such a taxpayer should consider whether the benefits of tax deferral under the like-kind exchange rules outweigh the benefit that they may get from the application of the home sale exclusion to any gain realized on a future sale of the property.
If the taxpayer determines that the benefits from future use of the home sale exclusion outweigh the benefits of tax deferral under the like-kind exchange rules, they should try to structure the exchange to intentionally fail the requirements of the like-kind exchange rules of IRC §1031, since the application of the like-kind exchange rules is mandatory if the requirements of IRC §1031 are satisfied. This is most likely to happen if the total amount of gain deferred is comparatively small compared to the amount the taxpayer expects the property received to appreciate over the next few years.
Observation: It is possible for an exchange to be treated as a tax-deferred like-kind exchange with respect to one of the parties, but not with respect to the other party, e.g., where one is an investor and the other is a dealer in properties.
Caution: If acquired property is converted soon after its acquisition in what purports to be a like-kind exchange, the IRS may effectively claim that deferral of recognition gain does not apply to the taxpayer acquiring that property (though it could still apply to the other party to the transaction) on the grounds that the acquiring taxpayer did not intend to hold the acquired property for productive use or for investment.
