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Hey there, fellow real estate investors, FIRE enthusiasts, and tax aficionados! Welcome to "Real Estate is Taxing" – your go-to weekly podcast for all things real estate taxes, hosted by Natalie Kolodij, EA- Real Estate Tax Strategist and dry humor extraordinaire.
Each week, we're breaking down complex tax topics into bite-sized, understandable explanations, with no regard for how many obscure references it takes to get there.
Welcome to Real Estate is Taxing, where we talk about all things real estate tax and break down complex concepts into understandable, entertaining tax topics. My name is Natalie Collati. I'm your host, and I am so excited that you've decided to join me. Hello. Hello.
Natalie:Thank you for tuning in. Thanks for listening, guys. Today, we're getting kind of a 2 for 1 show because we are going to talk about 2 of my favorite tax code section that we typically hear are very different, and you can't mix the rules on these, but we are going to talk about the several ways you can and clear up a few of the misconceptions related to this idea. So today, I wanna chat with you guys about when and how we can use a 121 exclusion with a 1031 exchange. As a little recap, the 1 21 exclusion allows a taxpayer to sell their primary home tax free as long as they have owned and occupied it for 2 out of the most recent 5 years.
Natalie:Like with all things, there's many exceptions to that, but that's the gist of it. Now this rule only applies to primary homes, and those are the only requirements is the occupancy and ownership tests. There is no requirement to buy anything else. I have heard people say that you can sell your primary home tax free as long as you're buying a new primary home. They're mixing up either one of 2 things here.
Natalie:There used to be a provision that required that decades ago hasn't been law in forever. They're either thinking about that old version of the law where you did have to purchase a new primary home, or they're mixing it up with this next concept, which is a 10 30 one exchange. So whereas a 1 21 exclusion applies only to primary homes, a 1031 exchange applies only to business or investment properties. They're typically oil and water. You can't do a 1031 on a primary home.
Natalie:You can't do a 121 on a rental. However, if as a kid, you had one of those little toys where you could flip it upside down and the little bubbles of different colored oil and water kind of mixed together and sort of played together, but they were still separating. That's what we've got going on here. So there are times when these 2 can be flipped together and kind of work unanimously for a little while before they go into their separate buckets. The first example of how we can overlap these 2 code provisions is with any property where there is both business and personal use.
Natalie:An example of this would be if you owned a duplex. If you have a duplex where both units are the same size and you've lived in it for 2 years, you've owned and occupied it for 2 years, During those 2 years, you rented out the other side. When you sold, only half of your gain related to your primary unit could you exclude under the 121 exclusion because it only applies to your actual dwelling unit. However, the gain related to that second side could be deferred using a 1031 exchange because it's from rental use. In a 1031 exchange, you do have to acquire a new property.
Natalie:In a 1031 exchange, you do have to acquire a new property. So for the gain from your primary unit, you could utilize the 121 exclusion and exclude your half of the gain up to $250,000 tax free. You don't need to buy anything else. And then with the gain related to the other rental unit, you would be able to defer it using a 1031 exchange. And you would need to purchase a new rental or business use property that was worth at least the amount of the gain you are deferring.
Natalie:So that's one of the more common ways that we can see these two code sections used together is if the property is mixed use. This will also come up with properties where there might be primary home and then a business on the same property. There might be a shop that you work out of, something like that. You can allocate between the 2, because you're going to have some business use gain and some personal. So you can use the business use 10 30 one exchange.
Natalie:You can also use the personal use 121 exclusion. The next example of a way we can use these two provisions together is any property where we might have switched between being a primary residence and being a rental at different times. When you sell your primary home, like I said earlier, typically the rule is 2 out of 5 most recent years, You can sell it tax free. However, we have something called nonqualified use, which basically is any other time during the time you owned it when that home wasn't used as your primary home. It does not include the time after you most recently used it as your primary home.
Natalie:So since you had to have used it 2 out of the most recent 5 years, this means that as long as you rent it for no more than 3 years after you move out, you can still sell it and receive your full 121 exclusion, because that time is specifically stated as not being nonqualified use. They said, don't count that. However, if you have business use or rental use before your most recent use as a primary home, it is nonqualified use. And what this means is even if you live in it for 2 years out of the most recent five, the gain related to all of those years before that when it was a rental is still going to be taxable, doesn't wipe that out. So if, for example, you've rented it for 8 years, then you moved into it for 2, only 2 tenths of your gain can you exclude under the 1 21 exclusion.
Natalie:The gain related to those first 8 years is still going to be taxable gain because it's from nonqualified use. The flip side is because the gain related to those 8 years that's taxable is related to rental use, you can defer the gain from those 8 years in a 10 30 one exchange. So if you have a property that you rented for years and then you moved into as a primary home, and you can now sell it and qualify for the primary home exclusion, you can do that on the portion of the years that it was your primary. And then the gain from those prior years when it was a rental, you could utilize a 10 30 one exchange. Now I know a minute ago, I said that the 3 years after the most recent time that you used it as a primary are not nonqualified use, meaning you can exclude the gain in its entirety if you only rented it after it was your primary, and you didn't rent it for any more than 3 years.
Natalie:The only thing you would pay back would be depreciation. However, there might be an instance when instead you want to treat those 3 years as rental gain, and you can. You are allowed to do that. So you can either roll it into your 121 exclusion, if that makes sense. And if you can, that's typically your best option because it is eliminating the gain, not deferring it till later.
Natalie:However, there might be circumstances where it makes more sense or where you can't include it in your 121 exclusion. What if you lived in a primary home for 20 years, and it's gone up in value tremendously, and it's a super hot market? It's going to keep going up in value. You can only exclude, as a single person, $250,000 worth of gain. But your agent says, I really think when you sell it, that the gain is going to be over that by a little bit.
Natalie:You know, it's going to be maybe 280, $290,000 worth of gain. So what you can do is you can move out of that house, rent it for 3 years, and now 3 years' worth of the gain, you can defer in a 1031 exchange. So you're pushing it off and buying another rental property. But the gain from all of those earlier years up to that $250,000 mark, you can exclude under your 121 exclusion. So sometimes, you may choose to convert a primary home to a rental if you think the amount of gain that you will have will surpass the amount you can exclude under that primary home sale exclusion, because now you also have some years qualifying as a different type of gain, qualifying as a business or rental use gain.
Natalie:The last common reason that you might want to utilize these two provisions together is if, on your primary home, you qualify for a circumstance where you can exclude all of your gain, you've lived in it for at least 2 out of 5 years, you didn't have nonqualified use ahead of time, When you sell it, you will qualify for your full 121 exclusion, and the gain won't surpass your $250,000 cap. But what the 121 exclusion does not allow you to exclude is depreciation recapture or unrecaptured 12 50 gain. So the first thing you might be thinking is, I can't depreciate my primary home. Why would I have that? If you had business use within your primary home, like you had a home office or you rented spare bedrooms, the way the tax code is written, you do not need to allocate part of the gain to those spaces as long as they're within your same dwelling unit.
Natalie:That's what makes this different from the first example with a duplex because it was a separate dwelling unit was rental use, and a separate dwelling unit was your primary home. If it is one unit, one dwelling unit, and it's just space within those same walls that you're using for a business use, when you sell, there's no allocation required. The full amount of gain can be excluded. However, there was still business use, and there was still depreciation on those spaces that were used for business. So another reason that you might want to consider doing a 1031 in conjunction with a 1 21 exclusion would be if you have a large amount of accumulated depreciation.
Natalie:If you've rented your 3 spare bedrooms in your house for 20 years, when you go to sell, even though your gain might be $230,000, you'll get to exclude the full amount of gain. If you have $50,000 that you have taken over the years of depreciation because of those 3 rental use bedrooms, that portion will still be taxable. You will still have to pay that unrecaptured 12.50 gain. So your other option is because that gain arises from business use, you can choose to use a 1031 exchange to defer only the part of the gain that is the depreciation recapture or that unrecaptured depreciation. So if you had $50,000 that was going to still be taxable, even though you were getting to use your 121 exclusion, because you had to depreciate those business use areas, you could do a 10.31 exchange for that $50,000 portion and defer that gain into the purchase of a new rental property.
Natalie:So a little more of a unique situation, but still might make sense. I want to wrap up this episode with a couple questions that come up when it comes to the overlap of these two code section. It's not uncommon for someone to ask if they can sell a rental property and do a 1031 exchange and purchase a new primary home? Can we start with 1 and end with the other or vice versa? And, typically, the answer is no.
Natalie:Right? A 1031 exchange is only for business use or rental use asset. However, with almost everything in tax, there's always an exception. So there are 2 main ways that you could end up kind of starting with 1 and ending with the other. The first is your plans change.
Natalie:So if you have a rental property and you complete a 10 30 one exchange into a new rental property, and then 2, two and a half, 3 years down the road, you end up needing to move into that rental property. Maybe your job changes. Maybe you need to move somewhere bigger because of a circumstance shift. Whatever the reason is, If that wasn't planned, if you bought it to be a rental, but then after it served its purpose as a rental for probably at least a year or 2, something changes and you have to move into it, that's okay. That's allowed.
Natalie:So you might do a 1031 exchange from 1 rental property to defer gain into another rental property and then down the road end up needing to move into it as your primary home. There is a caveat to this, where if there's a property that you are using as your primary home now and it was acquired, you purchased that property through a 1031 exchange. When you sell it, you cannot use any amount of the 121 primary home exclusion until the 5 year mark from when you purchased that property. So for example, if you did a 1031 exchange and you sold 1 rental, bought another rental, it was a rental property for 2 years, and then something changed and you had to move into it. You've lived in it for 2 years, and you think about selling it.
Natalie:You would not be able to sell it at that 4 year mark and use any part of the 1 21 tax free exclusion even though you've now lived in it for 2 years. Because there is a 5 year holding period on any property acquired through a 1031 exchange before you have the option of doing a 121 exclusion. So let's say the circumstances change a little bit. You find that out, so you realize you have to occupy the property for at least 1 more year. Right?
Natalie:So you bought it, you rented it for 2 years, then you moved in. You would have to live in it for at least 3 to hit that 5 year minimum requirement before you could do a 1 21 exclusion. Now even though you can now do a 1 21 exclusion, you will still have some taxable gain because of nonqualified use. The first two years of that property, when it was a rental before it was your primary, those 2 years are nonqualified use. So are all of the years of rental use of that original rental that you sold and deferred the gain in the 10/31.
Natalie:All of those years of rental use are still going to be taxable. It won't wipe that out. But now you can wipe out 3 years' worth of gain from the 3 years it was your primary residence. But the main point there is just life circumstances change, So there can very well be a situation where you sell a rental, do a 1031 exchange, buy a new rental, and then down the road, it converts into your primary home. So that can happen.
Natalie:If it does happen, you cannot take any part of a 121 primary home sale exclusion until you have owned that new property for at least 5 years. The other part to that question, the other sort of way you can use a 1031 exchange to purchase a new primary home is if the property is mixed use. So the same way you could use 8, 10, 31, and 121 together if a property had a primary home, but then also a shop or something for business. If you are selling a business asset, so you're selling, let's say, a rental property, and you're going to do a 1031 exchange into a new rental property, if the amount you need to exchange, let's say that new rental, to be able to defer all of your gain, not pay any tax, you need to buy a new rental property worth at least $200,000. Like, that's the amount of replacement property value you need to buy.
Natalie:If you find a duplex with 2 equal sized units that costs $400,000, you can buy that with your 1031 exchange. Only the value from the business portion of the replacement asset counts for your exchange. But because half of that value for the one half of the duplex that will be rental is going to be worth 200,000, it would meet the requirement. And then the other half of the property, the one that is effectively your primary unit, would need to be purchased through non 1031 funds. So that half of it would need to be funded with a loan or cash.
Natalie:But you can buy a property where part of it will be your primary home using a 1031 exchange. You can absolutely do that. You just cannot buy a property that is only going to be your primary home with the funds from a 10 30 one exchange, and you cannot buy the portion of a property that is going to be your primary home with the funds from the 1031 exchange. But if the portion of that replacement property that is business use equals the amount of replacement property you need. So if just that business use value meets that criteria for how much you need to buy, then it works.
Natalie:The last thing worth noting is while there are several kind of rules related to this, there's obviously nuances with everything, What the property is being used for currently doesn't change any of this. So if your property was your primary home first, like we said earlier, you can live in your home for years, and then you can choose to make it a rental for up to 3 years and still receive that full exclusion. Even though the day you are selling it and taking your 1 21 exclusion, it is being used as a rental property, it still qualifies. The use at the time of the sale doesn't matter. It is the types of gain that are being generated by the sale that matter, and what types of those gain count as personal, where we can exclude it under a 121 exclusion, and if there's some of that gain that qualifies as business or rental use, and if that can be deferred in a 1031 exchange, Whether it is being used as 1 or the other on the day of sale, that doesn't change the difference.
Natalie:So I hope you guys found today's episode to be helpful. Again, there's so much weird nuance and tax, and I love these weird little exceptions that people might not know about because this is how you keep from paying extra tax when one of these unique situations comes up. With any tax strategy, even if it's a fantastic tax strategy and you hear someone else talk about it and it saved them $1,000,000, it might not be the right strategy for you. It might not save you any money. But knowing a little bit about all of these different unique strategies is incredibly powerful because when a circumstance comes up that is sort of related to something you heard, you can then take it to your tax professional.
Natalie:Or if you're a tax professional listening, you can then research it farther and see if it applies for this circumstance. But if you have no idea it exists, you won't even know to start looking. So again, I hope you guys found this helpful. As always, I would love if you would subscribe and share and please leave a 5 star review wherever you love listening to podcasts. Additionally, if you have more questions or an idea for an upcoming show topic, come join us on Facebook.
Natalie:I have a group for tax professionals and a group for real estate investors. Links to both are in the show notes. Thanks to you guys, and I'll talk to you next week.