Can I 1031 exchange my primary residence or second home?

A residence fails the holding test, and expecting it to appreciate does not save it

The IRS collected the authority itself in the background to Rev. Proc. 2008-16, starting with Rev. Rul. 59-229, which refuses deferral to anyone trading one personal residence for another on the ground that neither side qualifies as business or investment property.

Taxpayers have tried the appreciation argument and lost. The Tax Court answered it in Moore v. Commissioner, T.C. Memo. 2007-134, where two lakeside holiday houses that had never been let were exchanged, holding that a "mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence."

Starker v. United States, 602 F.2d 1341, 1350 (9th Cir. 1979) states the principle the IRS still quotes: "it has long been the rule that use of property solely as a personal residence is antithetical to its being held for investment."

Section 121 is the homeowner's tool, and it is generous but capped

Section 121(a) excludes gain on the sale of a home you owned and used as your principal residence for at least two of the five years ending on the date of sale. Section 121(b) caps the exclusion at $250,000, or $500,000 for certain joint returns, and section 121(b)(3) blocks a second use of the exclusion within two years of a sale that already used it.

Two limits catch owners of long-held rentals-turned-homes. Section 121(d)(6) denies the exclusion for gain matching depreciation adjustments claimed for periods after 6 May 1997, and section 121(b)(5) apportions gain away from the exclusion for periods of non-qualified use.

If your gain sits comfortably under the cap, there is nothing to plan: sell, exclude, and move on. The planning question only opens when the gain is bigger than the exclusion, which is where the next section starts.

Two of five years means you can move out and still do both

The two-year use test looks back five years, so a home can be rented for up to three years and still satisfy section 121 on the sale. By that point it is also being held for investment, which is what section 1031 needs.

Rev. Proc. 2005-14 confirms both halves in its own Example 1. A house bought for $210,000 is a principal residence from 2000 to 2004, rented from 2004 until 2006 with $20,000 of depreciation claimed, then exchanged in 2006 for $10,000 of cash and a $460,000 townhouse the taxpayer intends to rent. The IRS notes that section 121 does not require the property to be the principal residence on the date of the exchange.

The numbers come out as follows in the ruling: amount realised $470,000, adjusted basis $190,000, realised gain $280,000, of which $250,000 is excluded under section 121 and $30,000 is deferred under section 1031.

The order is fixed: section 121 first, and the excluded gain then lifts your new basis

Rev. Proc. 2005-14 section 4.02(1) is explicit that section 121 must be applied to gain realised before applying section 1031. Section 4.02(2) then allows section 1031 to shelter the piece section 121 cannot reach, including the gain attributable to post-1997 depreciation.

Boot is treated unusually kindly here. Under section 4.02(3), cash or other non-like-kind property is taken into account only to the extent it exceeds the gain excluded under section 121, which is why the $10,000 of cash in the IRS's own example is not recognised at all.

Section 4.03 completes the loop: the excluded gain is treated as gain recognised, so it increases the replacement property's basis. In Example 1 the replacement basis is $430,000, being the $190,000 old basis plus the $250,000 excluded, less the $10,000 of cash received.

A second home qualifies only if the Rev. Proc. 2008-16 rental test is met

The safe harbour applies to a dwelling unit, defined as real property improved with a house, apartment, condominium or similar improvement providing sleeping space, bathroom and cooking facilities. It is effective for exchanges of dwelling units occurring on or after 10 March 2008.

For the property you are selling, the IRS will not challenge its status if you have owned it for at least 24 months immediately before the exchange and, in each of the two 12-month periods before it, the conditions below are met. The mirror-image test applies for 24 months after the exchange on anything you buy.

Personal use is measured under section 280A(d)(2), taking section 280A(d)(3) into account but not section 280A(d)(4), so days a relative stays rent-free count against you. Fair rental is judged on all the facts and circumstances when the rental agreement is entered into.

• Owned for at least 24 months immediately before the exchange, the "qualifying use period"
• Rented to another person at a fair rental for 14 days or more in each 12-month period
• Personal use no greater than 14 days or 10 percent of the days rented at fair rental, whichever is larger
• The first 12-month period ends the day before the exchange; the second ends the day before that period begins
• On the replacement side, the same tests run for 24 months after the exchange, and a failure means filing an amended return

Part home, part rental or farm: allocate the way you allocated depreciation

Where the residential and business portions sit inside the same dwelling unit, Treas. Reg. 1.121-1(e) treats the whole property as the principal residence for the two-year use test. Where the business portion is a separate structure, the gain allocated to it is not excludable unless you also met the use requirement for that part.

Rev. Proc. 2005-14 Example 2 shows the split: a $210,000 property comprising a house and a guesthouse used as a business office, allocated two-thirds and one-third by square footage, produces $100,000 excluded under section 121 on the residential share and $80,000 deferred under section 1031 on the business share.

Treas. Reg. 1.121-1(e)(3) requires basis and amount realised to be allocated by the same method used to determine depreciation adjustments, and the revenue procedure endorses square footage, citing Poague v. United States. A farmhouse on acreage, a duplex you half occupy or a shop behind the house all run on this machinery, so settle the square-footage split with your CPA or attorney while the contract can still be changed.

The five-year rule waiting on the other side

Section 121(d), as amended by section 840 of the American Jobs Creation Act of 2004, denies the section 121 exclusion where the property was acquired in an exchange to which section 1031 applied and is sold within the five-year period beginning on the date of acquisition. The provision is effective for sales or exchanges after 22 October 2004.

So the sequence of home, rental, exchange, new rental, new home works, but the clock on the far end is five years from acquiring the replacement, not two. If I move into my 1031 replacement, can I later sell it tax-free? and How long do I have to rent a 1031 replacement before I can move in? work through the waiting periods.