CONVERTING A RESIDENCE TO A RENTAL
“REVENUE PROCEDURE 2005-14: APPLYING §1031 AND §121 TO A SALE”
REVENUE PROCEDURE 2005-14
The IRS recently gave guidance on Revenue Procedure 2005-14 on how to report
exchanges of property used as a principal residence and for business/investment use
in the last five years. A property owner can convert a principal residence to a rental
property and later sell it and benefit from both IRC §121 (principal residence tax exclusion
rules) and IRC §1031 (investment property tax deferred exchange rules).
Property owners must comply with all the rules in both sections to qualify.
APPLICATION OF §121 AND §1031
If a property owner has owned and lived in a principal residence for at least 2 out of
the last 5 years preceding the sale of the principal residence, $250,000 if filing as a
single ($500,000 on a joint return) of the gain from the sale, except for any depreciation
taken on the property since May 6, 1997, can be excluded. IRC §121 does not
require the owner to live in the property at the time of the closing to qualify for the
gain exclusion. A principal residence does not qualify if it was purchased in a §1031
exchange within the previous five years.
In essence, the Treasury has declared that if an owner lives in the residence long
enough to meet the principal residence requirements, they may then convert the
house into a property “held for investment” which can qualify for a §1031 exchange.
(Note: Although there is no defined “holding period” to be considered “held for investment,”
many tax/legal advisors believe 1-2 years is sufficient barring any factors
which contradict an investment intent.) The property owner can perform an IRC
§1031 exchange and still be eligible for gain exclusion under IRC §121, even if it is
presently being used as a rental.
When the owner sells the home as an investment property, they must still meet all
the necessary requirements for a §1031 exchange. This includes hiring a Qualified
Intermediary prior to closing on the relinquished property and adhering to all the time
requirements of an exchange, such as identifying the replacement property within 45
calendar days from the sale date and purchasing all replacement properties within
180 days, or the owner’s tax filing date, whichever is earlier.
The property owner can exclude gain up to $250,000 (filing as a single) or $500,000
(filing jointly) under IRC §121 except for any depreciation taken on the property after
May 6, 1997. Realized gain is first excluded under IRC §121 and then is eligible for
deferral under IRC §1031.
The revenue procedure provides six examples that include illustrations of the treatment
of depreciation and boot in which both the benefit of §121 exclusion and
§1031 deferral could be used.
© 2006 Asset Preservation, Inc.
Asset Preservation, Inc. does not give tax or
legal advice. The information contained herein
should not be relied upon as a substitute for tax
or legal advice obtained from a competent tax
and/or legal advisor.
Please visit the “Tax Code/Legal References” section at apiexchange.com to read the full text of Revenue Procedure 2005-14. Information provided by:
Asset Preservation, Inc.
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