Using a 1031 exchange for a primary residence can be a bit complex, but it is possible under certain circumstances. The key is to understand how the rules of Section 1031 and Section 121 of the Internal Revenue Code can work together. At Deferred.com, we offer qualified intermediary services to help guide you through this process, and our “No Fee Exchange” can save you money.

First, let’s break down the basics. A 1031 exchange allows you to defer capital gains taxes on the sale of investment property by reinvesting the proceeds into a like-kind property. On the other hand, Section 121 allows you to exclude up to $250,000 of gain ($500,000 for married couples) from the sale of your primary residence, provided you meet the ownership and use tests (living in the home for at least 2 of the last 5 years).

Now, how do these two sections work together? If you have a property that has been used both as a primary residence and for investment purposes, you may be able to apply both Section 121 and Section 1031 to the sale. This is known as a “split treatment” transaction.

Here’s an example to illustrate how this might work:

Imagine you purchased a property for $300,000 and used it as your primary residence for three years. Then, you rented it out for two years. Now, you want to sell the property, which is valued at $500,000. You have claimed $20,000 in depreciation during the rental period.

1. Section 121 Exclusion: Since you lived in the property for at least 2 of the last 5 years, you can exclude up to $250,000 of gain under Section 121. In this case, your gain is $200,000 ($500,000 sale price – $300,000 purchase price), so you can exclude the entire gain under Section 121. However, the $20,000 gain attributable to depreciation is not eligible for exclusion under Section 121.
2. Section 1031 Exchange: The portion of the property used for investment (the rental period) can be eligible for a 1031 exchange. You can defer the $20,000 gain attributable to depreciation by reinvesting in a like-kind property. This is where Deferred.com comes in as your qualified intermediary. We would facilitate the exchange, ensuring that the proceeds from the sale are reinvested into a new investment property, allowing you to defer the capital gains tax on the depreciation recapture.

By using both Section 121 and Section 1031, you can maximize your tax benefits. You exclude the gain from the sale of your primary residence and defer the gain from the investment portion of the property. This strategy requires careful planning and execution, and that’s where our expertise at Deferred.com can be invaluable. We can guide you through the process, ensuring compliance with IRS regulations and helping you achieve the best possible outcome for your real estate investments.