Sale of a residence and like-kind exchanges (Part I: this two-part article examines how recent developments in the principal residence exclusion and like-kind exchanges affect mixed personal- and business-use property. Part I describes the basic interaction between Secs. 121 and 1031.).

• Author: Orbach, Kenneth N.

EXECUTIVE SUMMARY

* Sec. 121(d)(10) and Rev. Proc. 2005-14 control how mixed personal- and business-use property is handled under the principal residence exclusion and like-kind exchange rules.

* In mixed-use property situations, the taxpayer allocates sales proceeds in the same manner as for depreciation purposes.

* Rev. Proc 2005-14 applies the principles of interaction between Secs. 121 and 1033 to interactions between Secs. 121 and 1031.

Two recent developments have brought into sharp focus the interaction between the Sec. 121 gain exclusion for principal residence sales and the Sec. 1031 gain postponement rules for like-kind exchanges. The first is the addition of Sec. 121(d)(10) by Section 840(a) of the American Jobs Creation Act of 2004. That provision makes the Sec. 121 exclusion unavailable for a sale of a residence within five years after it was acquired in a Sec. 1031 exchange. (1) The second development is Rev. Proc. 2005-14, (2) which details how a "mixed use" property (i.e., some use as a principal residence and some use as a business property) is handled under Secs. 121 and 1031.

Both of these developments are discussed in this article. Part I, below, outlines Secs. 121 and 1031 and illustrates the interaction between the sale of a residence and the like-kind exchange rules. Part II, in the December 2005 issue, will describe and illustrate in detail Rev. Proc. 2005-14's principles.

Overview

A single taxpayer who has owned and used a residence as a principal residence for two of the five years prior to its sale may exclude up to $250,000 of the gain from disposition of the property. (3) If a joint return is filed for the sale year, up to $500,000 of the gain may be excluded, if (1) at least one of the spouses owned the property for two of the five years prior to its sale, (2) both spouses used it as their principal residence for two of the five years prior to its sale and (3) neither spouse excluded gain under Sec. 121 from a prior sale within two years of the current sale. (4)

As the property (or a portion of it) may have been rental property some time during the prior five-year period, the Code and regulations have to decide how such mixed use affects eligibility for the Sec. 121 exclusion. There are two types of mixed-use property: (1) a single dwelling unit that was either fully (i.e., entire property rented to tenants) or partially (e.g., a home office) used for nonpersonal use; or (2) a portion of the property separate from the dwelling unit was non-personal-use property. (5)

Mixed-Use Property

Single dwelling unit: Under Regs. Sec. 1.121-1(e)(1), no allocation of gain between the residential and nonresidential portions of a property is required for Sec. 121 purposes if both portions are within the same dwelling unit. (6) In addition, the exclusion generally does not apply to the realized gain to the extent of post-May 6, 1997 depreciation; pre-May 7, 1997 depreciation has no effect on the Sec. 121 exclusion. (7)

Example 1: P, a single taxpayer, acquires a house in 1996, rents it to tenants through 1998, moves into it as his principal residence in January 1999, (8) and sells it in 2005, realizing a gain of no more than $250,000. Depreciation was taken for 1996-1998, but the taxable gain is limited to the depreciation taken after May 6, 1997.

Even though P had occupied the property for all of the six years prior to its sale, some of the gain (equal to the post-May 6, 1997 depreciation) is still taxable. A portion of the gain is also taxable if P lived in the property, but used a portion of it to conduct a law practice and took depreciation after May 6, 1997 on that portion. (9)

Portion of property separate from dwelling unit: In many situations, the property may have a dwelling unit for which the taxpayer meets the Sec. 121 requirements, but he or she may not satisfy the use requirement as to other parts of the property separate from such unit. For instance, the property might have more than one dwelling unit, only one of which the taxpayer occupies as his or her principal residence (e.g., a townhouse with more than one dwelling unit). Or, the property may have a dwelling unit and non-residential-use elements (e.g., a farm with a dwelling unit and various outbuildings used for farming).

In such cases, the taxpayer must allocate the sale proceeds between the portion of the property eligible for the Sec. 121 exclusion and the...