Real Estate

March 13, 2024

7851 / Can the maximum exclusion be reduced for gain on the sale of a principal residence due to special circumstances?

<div class="Section1"> If the reason that a taxpayer does not meet the ownership and use requirements (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7848">7848</a>) is that the sale or exchange resulted from a change in place of employment, health, or unforeseen circumstances, a reduced maximum exclusion may be available. Under such circumstances, the ownership and use requirements (including the two-year limitation) will not apply, and the exclusion amount will be computed as described in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7852">7852</a>.<a href="#_ftn1" name="_ftnref1">1</a> According to the regulations, in order for a taxpayer to claim a reduced maximum exclusion under IRC Section 121, the reason for the sale or exchange must be a change in place of employment, health, or unforeseen circumstances. If a safe harbor applies (see below), a sale or exchange is deemed to have been made for one of those reasons. However, if a safe harbor does not apply, a sale or exchange is deemed to have been made for one of those reasons only if the primary reason for the sale or exchange was a change in place of employment, health, or unforeseen circumstances. Whether the requirements are satisfied depends upon all the facts and circumstances.<a href="#_ftn2" name="_ftnref2">2</a> Factors that may be relevant in determining the taxpayer’s primary reason for the sale or exchange include (but are not limited to) the extent to which: (1) the sale or exchange and the circumstances giving rise to the sale or exchange are proximate in time; (2) the suitability of the property as the taxpayer’s principal residence materially changes; (3) the taxpayer’s financial ability to maintain the property is materially impaired; (4) the taxpayer uses the property as the taxpayer’s residence during the period of the taxpayer’s ownership of the property; (5) the circumstances giving rise to the sale or exchange are not reasonably foreseeable when the taxpayer begins using the property as the taxpayer’s principal residence; and (6) the circumstances giving rise to the sale or exchange occur during the period of the taxpayer’s ownership and use of the property as the taxpayer’s principal residence.<a href="#_ftn3" name="_ftnref3">3</a> Change in place of employment. According to the regulations, a sale or exchange is due to a change in place of employment if, in the case of a “qualified individual” (i.e., the taxpayer, the taxpayer’s spouse, a co-owner of the house, or a member of the taxpayer’s household), the primary reason for the sale or exchange is a change in the location of the individual’s employment.<a href="#_ftn4" name="_ftnref4">4</a> Under the distance safe harbor, a sale or exchange is deemed to be by reason of a change in place of employment if: (1) the change occurs during the period of the taxpayer’s ownership and use of the property as the taxpayer’s principal residence; and (2) the qualified individual’s new place of employment is at least 50 miles farther from the residence sold or exchanged than was the former place of employment (or, if there was no former place of employment, the distance between the qualified individual’s new place of employment and the residence sold or exchanged is at least 50 miles).<a href="#_ftn5" name="_ftnref5">5</a> Health reasons. A sale or exchange is due to health reasons if the primary reason for the sale or exchange is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a “qualified individual” (described above), or to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury. A sale or exchange that is merely beneficial to the general health or well-being of the individual is not a sale by reason of health.<a href="#_ftn6" name="_ftnref6">6</a> Under the physician’s recommendation safe harbor, a sale or exchange is deemed to be by reason of health if a physician recommends a change of residence for reasons of health.<a href="#_ftn7" name="_ftnref7">7</a> Unforeseen circumstances. A sale or exchange is caused by unforeseen circumstances if the primary reason for the sale or exchange is the occurrence of an event that the taxpayer could not have reasonably anticipated before purchasing and occupying the residence. A sale or exchange that occurred because of unforeseen circumstances does not qualify for the reduced maximum exclusion if the primary reason for the sale or exchange is a preference for a different residence or an improvement in financial circumstances.<a href="#_ftn8" name="_ftnref8">8</a> Under the specific event safe harbor, a sale or exchange is deemed to occur because of unforeseen circumstances if any of the events listed below occur during the period of ownership and use of the residence as the taxpayer’s principal residence: (1) the involuntary conversion of the residence; (2) natural or man-made disasters or acts of war or terrorism resulting in a casualty to the residence (without regard to deductibility under IRC Section 165(h)); or, (3) in the case of a “qualified individual” described above (a) death, (b) the cessation of employment as a result of which the individual is eligible for unemployment compensation, (c) a change in employment or self-employment status that results in the taxpayer’s inability to pay housing costs and reasonable basic living expenses for the taxpayer’s household, (d) divorce or legal separation under a decree of divorce or separate maintenance, or (e) multiple births resulting from the same pregnancy.<a href="#_ftn9" name="_ftnref9">9</a> In addition, the Commissioner may designate other events or situations as unforeseen circumstances in published guidance of general applicability, or in a ruling directed to a specific taxpayer.<a href="#_ftn10" name="_ftnref10">10</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 121(c)(2). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.121-3(b). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.121-3(b). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. §§ 1.121-3(c)(1), 1.121-3(f). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.121-3(c)(2). <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. § 1.121-3(d)(1). <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. § 1.121-3(d)(2). <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 1.121-3(e)(1). <a href="#_ftnref9" name="_ftn9">9</a>. Treas. Reg. § 1.121-3(e)(2). <a href="#_ftnref10" name="_ftn10">10</a>. Treas. Reg. § 1.121-3(e)(3). See e.g., Let. Rul. 200725018 (remarriage resulting in new blended family consisting of seven children from prior marriages); Let Rul. 200702032 (airport noise); CCA 200630015 (military exception); Let. Ruls. 200630004 (carjacking at taxpayer’s residence), 200626024 (special needs of mother-in-law), 200615011 (undercover narcotics investigator’s identity revealed, family was threatened), 200613009 (newly adopted child), 200601023 (grandchild, recently divorced daughter needing a place to live), 200601022 (birth of additional child), 200601009 (assault of family member at taxpayer’s residence), 200504012, and 200403049. </div></div>

March 13, 2024

7849 / Can gain from the sale of property that was used only partly as a principal residence be excluded from income?

<div class="Section1">IRC Section 121 does not apply to the gain allocable to any portion of property that is separate from the “dwelling unit” to which a taxpayer does not satisfy the use requirement. A taxpayer is not required to allocate gain if both the residential and business portions of the property are within the same dwelling unit. Although the taxpayer must pay tax on the gain equal to the total depreciation taken after May 6, 1997, he or she may exclude any additional gain on the residence up to the maximum amount. However, if the business portion of the property is separate from the dwelling unit, the taxpayer is required to allocate the gain, and is able to exclude only the portion of the gain attributable to the residential unit.<a href="#_ftn1" name="_ftnref1">1</a> The term “dwelling unit” has the same meaning as in IRC Section 280A(f)(1), but does not include appurtenant structures or other property.<a href="#_ftn2" name="_ftnref2">2</a> The method for determining the amount of gain allocable to the residential and nonresidential portions of the property is explained in Treasury Regulation Section 1.121-1(e)(3).<div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. § 1.121-1(e)(1). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.121-1(e)(2). </div></div>

March 13, 2024

7853 / What special rules apply in calculating the exclusion for gain on the sale of a principal residence?

<div class="Section1"> Editor’s Note: The 2017 tax reform legislation modified the mortgage interest deduction and the deductions for home equity interest and interest on debt related to refinancing. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8032">8032</a> for details. The treatment of certain mortgage insurance premiums as qualified residence interest was extended through 2021 by CAA 2021 (this treatment expired after 2021). The ability of certain taxpayers to exclude a discharge of qualified principal residence indebtedness from gross income has been extended through 2025. Property of deceased spouse. For purposes of the exclusion, in the case of a surviving spouse, the period in which the deceased spouse owned and used the property as a principal residence will be attributed to the surviving spouse.<a href="#_ftn1" name="_ftnref1">1</a> The regulations state this rule applies if (1) the taxpayer’s spouse is deceased on the date of the sale of the property; and (2) the taxpayer has not remarried at the time of the sale of the property.<a href="#_ftn2" name="_ftnref2">2</a> The Service privately ruled that if a surviving spouse who holds a “5 or 5 power” (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="824">824</a>) in a trust sells the personal residence, the gain on the residence will be taxable to the trust as the owner of the corpus, and not the surviving spouse, except to the extent the surviving spouse is treated as the owner of a portion of the property pursuant to a “5 or 5 power.”<a href="#_ftn3" name="_ftnref3">3</a> Property owned by former spouse. If property is transferred to the taxpayer by a former spouse pursuant to a divorce decree, the period in which the individual taxpayer owns the property includes the period that the former spouse owned the property. If property is used by a former spouse pursuant to a divorce decree, but is still owned by the taxpayer, the taxpayer is treated, solely for the purposes of this exclusion, as using the property as a principal residence during the use by the former spouse.<a href="#_ftn4" name="_ftnref4">4</a> Tenant-stockholder in cooperative housing corporation. If a taxpayer is a tenant stockholder in a cooperative housing corporation, the ownership requirement is applied to the holding of the stock, and the use requirement is applied to the house or apartment that the taxpayer is entitled to occupy as a stockholder.<a href="#_ftn5" name="_ftnref5">5</a> The Service has determined that tenant-stockholders were allowed to exclude $500,000 of gain from the disposition of their shares of stock in their cooperative apartment, which was coordinated with a donation of the same shares to a charitable organization.<a href="#_ftn6" name="_ftnref6">6</a> Sales of remainder interests. The exclusion applies to gain recognized on the sale or exchange of a remainder interest in a principal residence, provided that the sale or exchange is not to certain related persons; however, the exclusion does not apply to any other interest in such a residence that is sold or exchanged separately.<a href="#_ftn7" name="_ftnref7">7</a> For the explanation of how to make the election to apply the exclusion to gain from the sale or exchange of a remainder interest, see Treasury Regulation Section 1.121-4(e)(2)(iii). For the rules governing sales or exchanges of partial interests other than remainder interests, see Treasury Regulation Section 1.121-4(e)(1). Treatment of exclusion in bankruptcy cases. According to the regulations and earlier case law (both of which appear to ignore IRC Section 121(f)), the bankruptcy estate of an individual in a Chapter 7 or Chapter 11 bankruptcy case succeeds to and takes into account the individual’s IRC Section 121 exclusion with respect to the property transferred into the estate if the individual satisfies the requirements of IRC Section 121.<a href="#_ftn8" name="_ftnref8">8</a> Military Tax Relief A taxpayer on “qualified official extended duty” in the U.S. Armed Services or the Foreign Service may suspend, for up to 10 years of such duty time, the running of the five-year ownership-and-use period before the sale of a residence. Qualified official extended duty means any “extended duty” (1) while serving at a duty station that is at least 50 miles from the residence, or (2) while residing under government orders in government housing. “Extended duty” means a period of more than 90 days, or for an indefinite period. This election applies to only one property at a time; furthermore, the taxpayer may exclude gain on only one home sale in any two-year period. An election may be revoked at any time.<a href="#_ftn9" name="_ftnref9">9</a> Mortgage Forgiveness Debt Relief Act of 2007 Under MFDRA 2007, certain discharges of indebtedness on a principal residence have been excludable from gross income, but the date of expiration of this special provision is in doubt.<a href="#_ftn10" name="_ftnref10">10</a> See editor’s note, above. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 121(d)(2). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.121-4(a)(1). <a href="#_ftnref3" name="_ftn3">3</a>. Let. Rul. 200104005. <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 121(d)(3); Treas. Reg. §§ 1.121-4(b)(1), 1.121-4(b)(2). See, e.g., IRS INFO 2005-055, at www.irs.gov/pub/irs-wd/05-0055.pdf. <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 121(d)(4); Treas. Reg. § 1.121-4(c). <a href="#_ftnref6" name="_ftn6">6</a>. FSA 200149007. <a href="#_ftnref7" name="_ftn7">7</a>. IRC § 121(d)(8); Treas. Reg. §§ 1.121-4(e)(2)(ii)(A), 1.121-4(e)(2)(ii)(B). <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 1.1398-3. <a href="#_ftnref9" name="_ftn9">9</a>. IRC § 121(d)(9). <a href="#_ftnref10" name="_ftn10">10</a>. See IRC § 108(a)(1)(E). </div></div>

March 13, 2024

7855 / Can a taxpayer elect to not apply the otherwise available exclusion for gain on the sale or exchange of a principal residence?

<div class="Section1">A taxpayer may make an election not to have the exclusion of gain on the sale or exchange of a principal residence apply. If this election is made, the gain from the sale or exchange of a principal residence would not be excluded.<a href="#_ftn1" name="_ftnref1">1</a><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 121(f); Treas. Reg. § 1.121-4(g). </div></div>

March 13, 2024

7848 / What ownership and use requirements apply if a taxpayer wishes to take advantage of the exclusion for gain on the sale of a principal residence?

<div class="Section1"> In order to claim the full amount of the exclusion, the taxpayer generally must have owned and used the residence as his or her principal residence for an aggregate of two years during the five years prior to the sale or exchange.<a href="#_ftn1" name="_ftnref1">1</a> Additionally, the full amount of the exclusion cannot be claimed if the taxpayer took the exclusion for a prior sale during the two-year period ending on the date of the sale or exchange.<a href="#_ftn2" name="_ftnref2">2</a> For an explanation of the term “use of” property, see Gummer v. U.S.<a href="#_ftn3" name="_ftnref3">3</a> The ownership and use requirements for periods aggregating two years or more may be satisfied by establishing ownership and use for 24 full months or for 730 days (365 × 2). The ownership and use requirements do not have to be satisfied simultaneously so long as both tests are satisfied during the five-year period ending on the date of the sale.<a href="#_ftn4" name="_ftnref4">4</a> To establish that a taxpayer has satisfied the two-year use requirement, occupancy of the residence is required. However, short temporary absences, such as for vacation or other seasonal absence (although accompanied with rental of the residence), are counted as periods of use.<a href="#_ftn5" name="_ftnref5">5</a> For example, a one-year sabbatical leave abroad is not considered to be a short temporary absence; on the other hand, a two-month summer vacation does count as a short temporary absence.<a href="#_ftn6" name="_ftnref6">6</a> Determination of use during period of out-of-residence care. If a taxpayer has become mentally or physically incapable of self-care, and the taxpayer sells or exchanges property that he or she owned and used as a principal residence for periods aggregating at least one year during the five-year period preceding the date of the sale, an exception to the use requirement applies. Such a taxpayer will be treated as using the property as the principal residence for any period of time during the five-year period in which the taxpayer owns the property and resides in any facility (including a nursing home) licensed by a state or a political subdivision to care for an individual in the taxpayer’s condition.<a href="#_ftn7" name="_ftnref7">7</a> Ownership by trusts. If a residence is held by a trust for a period in which the taxpayer is treated (under the grantor trust rules) as the owner of the trust (or the portion of the trust that includes the residence), the taxpayer will be treated as owning the residence during that period for purposes of satisfying the two-year ownership requirement of IRC Section 121. Accordingly, the sale or exchange of the residence by the trust will be treated as if made by the taxpayer.<a href="#_ftn8" name="_ftnref8">8</a> The Service has privately ruled that the income beneficiary of a trust, which held her mother’s residence as its only asset, was not considered the owner of the residence because she lacked the power to vest the trust corpus or income in herself; thus, the gain on the home was not excludable under IRC Section 121.<a href="#_ftn9" name="_ftnref9">9</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 121(a); Treas. Reg. § 1.121-1(a). <a href="#_ftnref2" name="_ftn2">2</a>. Sales or exchanges prior to May 7, 1997, are not taken into account for the purposes of this two-year limitation. IRC § 121(b)(3); Treas. Reg. § 1.121(b). <a href="#_ftnref3" name="_ftn3">3</a>. 98-1 USTC ¶ 50,401 (Fed. Cl. 1998). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.121-1(c)(1)(i). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.121-1(c)(2)(i). <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. § 1.121-1(c)(4), Ex. 4 and Ex. 5. See, e.g., Taylor v. Comm., TC Summ. Op. 2001-17. <a href="#_ftnref7" name="_ftn7">7</a>. IRC § 121(d)(7); Treas. Reg. § 1.121-1(c)(2)(ii). <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 1.121-1(c)(3)(i). <a href="#_ftnref9" name="_ftn9">9</a>. Let. Rul. 200018021. </div></div>

March 13, 2024

7852 / If the maximum exclusion for gain on the sale of a principal residence is reduced because of a change in the taxpayer's place of employment, health, or unforeseen circumstances, how is the reduced maximum exclusion calculated?

<div class="Section1"> The reduced maximum exclusion is computed by multiplying the maximum dollar limitation of $250,000 ($500,000 for certain joint filers) by a fraction. The numerator of the fraction is the shortest of: (1) the period that the taxpayer owned the property during the five-year period ending on the date of the sale or exchange; (2) the period that the taxpayer used the property as a principal residence during the five-year period ending on the date of the sale or exchange; or (3) the period between the date of a prior sale of property for which the taxpayer excluded gain under IRC Section 121 and the date of the current sale or exchange. The numerator of the fraction may be expressed in days or months. The denominator of the fraction is 730 days or 24 months (depending on the measure of time used in the numerator).<a href="#_ftn1" name="_ftnref1">1</a> Thus, for example, a single taxpayer who would otherwise be permitted to exclude $250,000 of gain, but who has owned and used the principal residence for only one year and is selling it due to a job transfer, the fraction would be ½ and the maximum excludable amount would be $125,000 [½ × $250,000].<a href="#_ftn2" name="_ftnref2">2</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. § 1.121-3(g)(1); see also IRC § 121(c)(1). <a href="#_ftnref2" name="_ftn2">2</a>. See, e.g., Treas. Reg. § 1.121-3(c), Ex. 1; General Explanation of Tax Legislation Enacted in 1998 (the 1998 Blue Book), p. 166. </div></div>

March 13, 2024

7850 / What limitations apply to a taxpayer's ability to exclude gain from the sale of a principal residence from income?

<div class="Section1"> Generally, the amount of gain that may be excluded is $250,000. A taxpayer is eligible for only one maximum exclusion per principal residence.<a href="#_ftn1" name="_ftnref1">1</a> Married couples may exclude up to $500,000 if: (1) they file a joint return for the taxable year of the sale; (2) either spouse meets the two-year ownership requirement (described in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7848">7848</a>); (3) both spouses meet the two-year use requirement (described in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7848">7848</a>); and (4) neither spouse is ineligible to use the exclusion as a result of having taken the exclusion in the two-year period ending on the date of the sale.<a href="#_ftn2" name="_ftnref2">2</a> For married taxpayers filing jointly, if either spouse does not meet the requirements described in the preceding paragraph, the maximum dollar limitation is the sum of each spouse’s limitation amount, determined on a separate basis as if the spouses had not been married. For this purpose, each spouse is treated as owning the property during the entire period that either spouse owned it.<a href="#_ftn3" name="_ftnref3">3</a> In other words, the full or incremental amounts of gain that would have been allowable as an exclusion to the spouses separately, if each had been single and each had owned the property throughout the period in which one spouse owned it, are added together to obtain a maximum exclusion amount. For unmarried taxpayers who jointly own a principal residence, but file separate returns, each taxpayer may exclude up to $250,000 of gain that is attributable to each taxpayer’s interest in the property (if the requirements of IRC Section 121 have otherwise been met).<a href="#_ftn4" name="_ftnref4">4</a> Special rule for certain sales by surviving spouses. If a sale of property by a surviving spouse occurs not later than two years after the deceased spouse’s date of death, and the requirements for meeting the $500,000 exclusion (see above) were met immediately before the date of the spouse’s death, the $500,000 limit applies. This provision applies to sales or exchanges occurring after December 31, 2007.<a href="#_ftn5" name="_ftnref5">5</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 121(b); Treas. Reg. § 1.121(a)(1). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 121(b)(2)(A); Treas. Reg. § 1.121(a)(3)(i). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 121(b)(2)(B); Treas. Reg. § 1.121(a)(3)(ii). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.121(a)(2). <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 121(b)(4), as added by MFDRA 2007. </div></div>

March 13, 2024

7854 / Do the rules that apply in excluding gain from the sale or exchange of a taxpayer's principal residence apply in the case of an involuntary conversion?

<div class="Section1"> For purposes of the exclusion of gain on the sale or exchange of a principal residence, the destruction, theft, seizure, requisition, or condemnation of property is treated as a sale or exchange. For purposes of applying IRC Section 1033 (involuntary conversions), the amount realized from the sale or exchange of the taxpayer’s principal residence is equal to the amount of gain (determined without regard to this exclusion), reduced by the exclusion. If the basis of the property acquired as a result of an involuntary conversion is determined, in whole or in part, under the involuntary conversion rules, the holding period and use by the taxpayer of the converted property will be treated as the holding and use by the taxpayer of the property sold or exchanged.<a href="#_ftn1" name="_ftnref1">1</a> The Service has determined that for purposes of IRC Section 121(d)(5), the question of whether the “destruction” of a taxpayer’s principal residence has occurred is a question of fact.<a href="#_ftn2" name="_ftnref2">2</a> Following several national disasters, such as Hurricane Katrina, Congress extended from two to five years the replacement period in which a taxpayer could replace property that was located in the disaster area and that was compulsorily or involuntarily converted. The extended replacement period applied only if substantially all of the use of the replacement property was in the disaster area.<a href="#_ftn3" name="_ftnref3">3</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 121(d)(5); see Treas. Reg. § 1.121-4(d). <a href="#_ftnref2" name="_ftn2">2</a>. IRS CCA 200734021. <a href="#_ftnref3" name="_ftn3">3</a>. See, e.g., KETRA 2005 § 405; Heartland, Habitat, Harvest and Horticulture Act of 2008 (extending replacement period to five years for victims of Kansas tornadoes in May 2007). </div></div>

March 13, 2024

7856 / How is the exclusion for gain on the sale of a principal residence coordinated with the like-kind exchange rules?

<div class="Section1"> If a taxpayer acquires property in a like-kind exchange under which gain is not recognized (in whole or in part) by the taxpayer under IRC Sections 1031(a) or 1031(b), the exclusion of gain under IRC Section 121(a) does not apply to the sale or exchange of such property by the taxpayer (or by any person whose basis in the property is determined, in whole or in part, by reference to the basis in the hands of the taxpayer) during the five-year period beginning with the date of the acquisition.<a href="#_ftn1" name="_ftnref1">1</a> The Service and the Treasury Department have released guidance on how to handle a like-kind exchange of a home taking into account IRC Section 121 (home sale gain exclusion) and IRC Section 1031 (like-kind gain deferral).<a href="#_ftn2" name="_ftnref2">2</a> The revenue procedure clarifies that a homeowner who may exclude gain upon a sale or exchange of a home may also benefit from a deferral of gain for a like-kind exchange with respect to the same property. IRC Section 1031 provides that in the case of business or investment property (with some exceptions), a property owner generally would not recognize gain upon the exchange of the property for replacement property of a like kind.<a href="#_ftn3" name="_ftnref3">3</a> The property owner would recognize any gain to the extent received in cash or property that is not of a like kind (“boot”)<a href="#_ftn4" name="_ftnref4">4</a> (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7838">7838</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7839">7839</a>). Property used solely as a home would not constitute business or investment property for these purposes, and an exchange of such property would therefore be ineligible for nonrecognition under IRC Section 1031. The revenue procedure indicates that a homeowner may benefit from both the home sale exclusion and the like-kind deferral in cases where the property has been used consecutively or concurrently as a home and a business (e.g., rental residence). The basic rules for applying these statutory provisions are as follows: (1) When computing gain, IRC Section 121 must be applied to the realized gain before applying IRC Section 1031. (2) Although IRC Section 121 does not apply to gain attributable to depreciation deductions that have been claimed with respect to the business or investment portion of a residence, IRC Section 1031 may apply to such gain. (3) When “boot” (i.e., cash or other property not of a like kind) is received in exchange for relinquished business property, the boot is taken into account only to the extent that it exceeds the gain excluded under IRC Section 121 with respect to the relinquished business property. (4) When computing the basis of the replacement business property, any gain excluded under IRC Section 121 is treated as gain recognized by the taxpayer. Thus, the basis of the replacement business property is increased by any gain attributable to the relinquished business property excluded under IRC Section 121. Several examples are provided in the revenue procedure.<a href="#_ftn5" name="_ftnref5">5</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 121(d)(10). <a href="#_ftnref2" name="_ftn2">2</a>. Rev. Proc. 2005-14, 2005-1 CB 528. <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 1031(a). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 1031(b). <a href="#_ftnref5" name="_ftn5">5</a>. Rev. Proc. 2005-14, 2005-1 CB 528. </div></div>

March 13, 2024

7843 / What is a deferred exchange of real estate? When will this type of exchange qualify as a like-kind exchange?

<div class="Section1"> Where B wants title to A’s property before suitable replacement property has been located, the IRC specifies a limited period of time that may elapse after property is relinquished in a transfer and before the replacement property to be received is identified and transferred. For purposes of IRC Section 1031, the regulations, and this discussion, a deferred exchange is any exchange in which, pursuant to an agreement, the taxpayer transfers property held for productive use in a trade or business or for investment (i.e., the “relinquished property”) and subsequently receives property to be held for productive use in a trade or business or for investment (i.e., the “replacement property”).<a href="#_ftn1" name="_ftnref1">1</a> Transfers in which property is conveyed in return for a promise to acquire and convey acceptable replacement property by a certain future date were permitted under case law predating the 1984 revision of IRC Section 1031.<a href="#_ftn2" name="_ftnref2">2</a> The IRC states that to be treated as of like kind to relinquished property, the replacement property must be (1) identified as the property to be received in the exchange on or before the 45th day after the property relinquished in the exchange is transferred (i.e., the “identification period”), and (2) received within 180 days after the transfer of the property relinquished or, if earlier, the due date (including extensions) of the transferor’s income tax return for the tax year in which the transfer of the relinquished property occurred (i.e., the “exchange period”).<a href="#_ftn3" name="_ftnref3">3</a> “Identified” and “received,” for this purpose, are defined in the regulations as explained below. Regulations provide that replacement property is “identified” only if it is unambiguously described and designated as such in a written document, signed by the taxpayer and delivered (faxed, mailed, etc.), before the end of the identification period, to the person obligated to transfer the replacement property, or to any other person involved in the exchange (e.g., an escrow agent or a title company), other than the taxpayer or a “disqualified person” (defined below).<a href="#_ftn4" name="_ftnref4">4</a> However, replacement property actually received before the end of the identification period will be treated as identified.<a href="#_ftn5" name="_ftnref5">5</a> Because it is not always possible for a taxpayer to identify with precision the replacement property that will ultimately be received, the regulations permit identification of alternative properties. The maximum number of properties that may be identified as replacement property in a single deferred exchange is: (1) three properties, without regard to their fair market values; or (2) any number of properties, as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the fair market value of the relinquished property as of the date of transfer.<a href="#_ftn6" name="_ftnref6">6</a> If, as of the end of the identification period, the taxpayer has identified more replacement properties than permitted under the above rules, he or she will generally be treated as if no replacement had been identified. There are two exceptions to this general rule: First, any replacement property actually received before the end of the identification period will be treated as satisfying the requirements of the preceding paragraph. Second, a special “95 percent rule” may apply as follows: Any replacement property identified before the end of the identification period and received before the end of the exchange period will be treated as satisfying the requirements of the preceding paragraph if the taxpayer receives, before the end of the exchange period, identified replacement property having a fair market value that is at least 95 percent of the aggregate fair market value of all identified replacement properties.<a href="#_ftn7" name="_ftnref7">7</a> In order to meet the receipt requirement, the replacement property must be received before the end of the (180-day) exchange period, and the replacement property received must be substantially the same property as identified. If more than one replacement property was identified, these requirements apply separately to each replacement property.<a href="#_ftn8" name="_ftnref8">8</a> Special rules apply for identification and receipt of replacement property that does not yet exist or is being produced at the time relinquished property is transferred.<a href="#_ftn9" name="_ftnref9">9</a> For taxpayers implementing a deferred exchange, the necessity of protecting the owner of the relinquished property until the transaction is completed often results in the use of an intermediary and some form of guarantee to secure the obligations of the transferee. Two issues that have tended to result in frequent challenges by the IRS to complex deferred like-kind exchanges are: (a) whether an intermediary is an agent of the taxpayer (see discussion in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7842">7842</a> on simultaneous exchanges) and (b) whether the taxpayer who receives cash or other security guaranteeing the transaction has constructively received payment for the transfer, thus having made a sale rather than an exchange.<a href="#_ftn10" name="_ftnref10">10</a> Regulations address these problems by providing four safe harbors designed to help taxpayers engaging in deferred exchanges avoid such challenges. (Of these four, only one, the qualified intermediary safe harbor, is also applicable to simultaneous exchanges; see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7842">7842</a>.) <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. § 1.1031(k)-1(a). <a href="#_ftnref2" name="_ftn2">2</a>. See Starker v. U.S., 75-1 USTC ¶ 9443 (D. Or.) (Starker I); Starker v US, 602 F.2d 1341, 79 USTC ¶ 9541 (9th Cir. 1979) (Starker III), rev’g 432 F. Supp. 864, 77 USTC ¶ 9512 (D. Or. 1977) (Starker II). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 1031(a)(3). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.1031(k)-1(c). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.1031(k)-1(c)(1). <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. § 1.1031(k)-1(c)(4)(i). <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. § 1.1031(k)-1(c)(4)(ii). <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 1.1031(k)-1(d)(1). <a href="#_ftnref9" name="_ftn9">9</a>. Treas. Reg. § 1.1031(k)-1(e). <a href="#_ftnref10" name="_ftn10">10</a>. See See Garcia v. Comm., 80 TC 491 (1983), acq., 1984-1 CB 1. </div></div>