Sale of a residence and like-kind exchanges: 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 II examines how Rev. Proc. 2005-14 applies secs. 121 and 1031 to sales and like-kind exchanges of such property.

• Author: Orbach, Kenneth N.
• Position: Part 2

EXECUTIVE SUMMARY

* Rev. Proc. 2005-14 provides five basic principles for applying the Sec. 121 residence exclusion and Sec. 1031 like-kind exchange rules to mixed-use property.

* The tax consequences of a sale and exchange of mixed-use property vary according to the facts.

* Tax advisers should warn clients that the Sec. 121 exclusion is not available for five years after replacement property is received in a like-kind exchange.

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This two-part article analyzes how a mixed-use property (i.e., some use as both a principal residence and as a business property) is handled for purposes of the Sec. 121 principal residence exclusion and Sec. 1031 like-kind exchange rules. Part I, in the November 2005 issue, explained the general interaction between Secs. 121 and 1031. Part II, below, describes and illustrates in detail the principles applicable to mixed-use property under Rev. Proc. 2005-14. (23)

Rev. Proc. 2005-14

Basic Principles

Principle #1: Taxpayers within the scope of the procedure may apply both the Sec. 121 exclusion and the Sec. 1031 nonrecognition provisions to the same transaction.

Principle #2: The Sec. 121 gain exclusion is applied before Sec. 1031 gain postponement.

Principle #3: The post-May 6, 1997 depreciation-related gain otherwise recognized under Sec. 121 may be postponed under Sec. 1031.

Principle #4: In applying Sec. 1031, boot is taken into account only to the extent it exceeds the Sec. 121 excluded gain attributable to the relinquished business property.

Principle #5: The basis of the replacement trade or business or investment property is increased by the Sec. 121 excluded gain (i.e., the excluded gain is treated as additional recognized gain for purposes of the Sec. 1031(d) calculation of the replacement property's basis (24)).

Examples

These principles are illustrated in the examples below.

Example 1--Single dwelling unit, no mixed use at sale: Single taxpayer A purchased a house on Jan. 3, 2000 for $200,000 and immediately resided in it. She previously rived in a rental apartment. A used the house as her principal residence until Dec. 31, 2004, when she moved in with her fiance. Under Sec. 121, A has until Dec. 31, 2007 to sell or exchange the house and still qualify for an exclusion. In other words, she has a three-year "window" within which she continues to qualify for exclusion under Sec. 121. (25) From Jan. 1, 2005 until June 30, 2006, A rents the house to tenants and claims $10,900 depreciation. (26) On July 1, 2006, A exchanges the house for $10,000 and a townhouse (building and land) with a $435,000 FMV. A rents the townhouse to tenants.

Because A owned and used the house for at least two years during the five-year period ending on July 1,2006 (the exchange date), she may exclude her gain under Sec. 121. (27) Because the property is rental property on July 1, 2006, and A intends to hold the townhouse as rental property, Sec. 1031 also applies. Under Rev. Proc. 2005-14, Sec. 121 applies first (Principle 2).The tax consequences of the exchange follow.

1. Compute realized gain without regard to Secs. 121 and 1031:

   Original cost $200,000 Depreciation 10,900 Adjusted basis (at time of exchange) $189,100 Replacement properly $435,000 Cash 10,000 Amount realized $445,000 Less: adjusted basis of relinquished properly 189,100 Realized gain on relinquished property $255,900 2. Apply Sec. 121: Sec. 121 does not apply to the first $10,900 (the depreciation taken on the relinquished house) of realized gain, under Sec. 121(d)(6). The remaining $245,000 gain is excluded from income under Sec. 121.

3. Apply Sec. 1031: Because the $245,000 excluded gain exceeds the $10,000 boot received, the entire $10,900 post-exclusion realized gain is deferred (i.e., not currently recognized) by Sec. 1031 under Rev. Proc. 2005-14, Section 4.02(3) (Principles 3 and 4). A's basis in the replacement townhouse is $424,100 ($435,000 townhouse FMV--$10,900 deferred gain); this amount may also be computed as $189,100 basis of the relinquished house + $245,000 excluded gain--$10,000 boot received (Principle 5).

   Alternative analysis: Because A has received more than one like-kind property (the townhouse consists of a building and land), the transaction is a multiple-property exchange for Sec. 1031 purposes. (28) Under Regs. Sec. 1.1031(j)-1, the properties in the July 2006 transaction are separated as follows:

1. The only exchange group in this example consists of (1) the replacement townhouse (land and building) with a $435,000 FMV and (2) the relinquished house with a $189,100 basis and a $445,000 FMV ($255,900 realized gain). (29)

2. Because the relinquished house's value exceeds the replacement townhouse's value by $10,000, the $10,000 received by A goes into the residual group. (30)

   The tax consequences are determined as follows:

1. Apply Sec. 121: Sec. 121 does not apply to the first $10,900 (the depreciation taken on the relinquished house) of the $255,900 realized gain, under Sec. 121(d)(6). The remaining $245,000 gain is excluded under Sec. 121.

2. Apply Sec. 1031: Because A excludes $245,000 of the realized gain, the amount realized on the house is reduced by $245,000 to $200,000 for Sec. 1031 purposes. (31) Thus, there is an exchange group surplus of $235,000 ($435,000 FMV of the townhouse received--$200,000 reduced amount realized on the relinquished house). Because there...