Tax Guru – Ker$tetter Letter

Helping real people win the tax game.

Tax Free Home Sales

Posted by taxguru on October 22, 2004

There are obviously tons of items in the just signed tax law that are of interest to various groups of people.

One that is of great interest to us has to do with people who sell homes that were originally acquired as part of a 1031 exchange. Effective tomorrow, the tax free exclusion of up to $250,000 of gain per person is only allowable if the property was originally acquired more than five years prior to the sale. The seller would also need to meet the test of occupying the property for the requisite two years.

Here is the actual text from the new law:

SEC. 840. RECOGNITION OF GAIN FROM THE SALE OF A PRINCIPAL RESIDENCE ACQUIRED IN A LIKE-KIND EXCHANGE WITHIN 5 YEARS OF SALE.

(a) IN GENERAL- Section 121(d) (relating to special rules for exclusion of gain from sale of principal residence) is amended by adding at the end the following new paragraph:

`(10) PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE- If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property.’.

(b) EFFECTIVE DATE- The amendment made by this section shall apply to sales or exchanges after the date of the enactment of this Act.

This doesn’t change or even codify how long a property has to be used for rental, business or investment purposes before it can be converted to a primary residence with no tax consequence. It only says that the Section 121 exclusion is not available if the home is sold in less than five years after its original acquisition.

This will put the property owners in a tricky situation. If it is being used at the time of sale as a primary residence, the entire gain will be taxable, including the deferred gain that had been rolled into the property via the 1031 exchange.

Since primary residences being disposed of are not eligible for 1031 exchange treatment, my initial reaction to this scenario would be to advise the property owners to consider converting the home back to rental usage for as long as possible prior to the sale and then set it up as a 1031 exchange into new rental property that can then be later converted into a primary residence.

This game plan would obviously be a lot of hassle; but the taxes could be substantial if these steps aren’t taken. Obviously, the property owners should work with their personal tax advisors to crunch their exact numbers to see if it makes sense.

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