Combining a 1031 exchange with a 121 exclusion is a powerful tax plan, but it’s important to note the many rules and regulations, which are always changing and growing. Our team at Diversified Investment Strategies can help you determine if this plan of action is right for you.
We often hear prospects state that they want to move into their investment property for two years and then sell it tax-free after making it their primary residence. If only it were that easy! Let us help you understand the implications behind this combined tax strategy.
With a 121 exclusion, you may sell property, which you’ve used for at least 24 months out of the last 60 months as your primary residence, and exclude up to $250,000 in capital gains if you are single, or up to $500,000 if you are married and filing a joint income tax return. As stated, there are limits on how much taxable income you can exclude.
The 121 exclusion only works for property that has been used as your primary residence. This does not include second homes, vacation homes or any type of property used as an investment or in your business, unless you combine it with a 1031 exchange. When combining the two, you may only exclude capital gains from taxable income, not depreciation.
Here are scenarios where it does work to combine a 1031 exchange with a 121 exclusion:
1. If you purchase property out right that was used as investment property, and you convert it into your primary residence, you can take advantage of a 121 exclusion. You must live in it for at least 24 months as your primary residence. You will only qualify for a partial tax-free exclusion, because the property was once used as investment property. However, this is not true if the property was used as rental property before Jan. 1, 2009. The longer you remain in the property as your primary residence, the more you can exclude from your taxable income.
2. If you purchase a property as your like-kind replacement property in a 1031 exchange, you must hold the property as an investment for 12 to 18 months or more before converting it into your primary residence. To qualify for a 121 exclusion, you must own the property for a minimum of five years, and you must live in it as your primary residence for a minimum of 24 months. This will also only qualify for a partial tax-free exclusion.
3. If you live in your primary residence and then convert it into investment property, you may qualify for a 121 exclusion and a 1031 exchange. The longer you hold the property as an investment property, the better, but at least 12 months is recommended. When you sell, you would exclude taxable income for a 121 exclusion, and then complete a 1031 exchange.
This can be a great tax strategy for homeowners with highly appreciated primary residences, but as you can see, there are many rules and stipulations to be followed. That’s what our team at DIS is here for! We can answer all of your questions and help guide you through which strategy makes the most sense for you, and which strategies you may qualify for. Give us a call, let’s discuss!