Selling a property as your Personal Residence and as an investment

Under Internal Revenue Code Section 121, a married couple can sell their personal residence and avoid paying taxes on up to $500,000 of the gain (or $250,000 for a single taxpayer).

What if that taxpayer moves out of that personal residence and rents it out for 2 years. In theory, they could then still sell the property as their primary residence and do a 1031 Exchange for any additional gain realized.

Let us assume John and Joan Doe purchased their primary residence in 1997 for $100,000 and they lived in the property as their Primary Residence until 2016. At that time, they moved out and started renting the property. By renting the property out for two consecutive years, they successfully converted the property to a qualifying “Investment Property” for the purpose of a 1031 Exchange. Revenue Procedure 2008-16.

John and Joan Doe are now ready to sell the property in 2018 (after 2 years of rental) for $1,000,000, with an adjusted basis of $100,000. They can utilize both §121 and §1031 as follows:

  • Sell the property for a net sales price of $1,000,000;

  • Take their full $500,000 exemption under §121. This allows John and Joan Doe to exclude $500,000 from their income;

  • However, because of the large amount of appreciation on the property, they are still subject to taxes on approximately $400,000 after deducting their $100,000 basis.

  • At this point, they can then perform a 1031 Exchange on the remainder of the net proceeds from the sale of the rental property. The investment requirements remain the same (as a normal 1031 exchange) to obtain a full deferral of taxes:

    • John and Joan Doe will need to buy a replacement for at least $500,000;

    • The amount of equity in the Replacement Property will need to be equal to or greater than the equity in the Relinquished Property;

    • The amount of debt in the Replacement Property will need to be equal to or greater than any debt paid off on the sale of the Relinquished Property.

For more information, please reach out to your tax professional for specific questions or contact the specialists here at Security 1st Exchange for assistance.


References

Revenue Procedures 2005-14 and 2008-16