Converting a Principal Residence to Minimize Taxes by Combining IRC з1031 and з121
When the ExchangerТs principal residence is used partially for business purposes, such as a home office or a duplex, half of which is rented, then the Exchanger must allocate it between the personal use and the business use. The portion allocated to business purposes qualifies for an IRC з1031 exchange and the residence portion may qualify for the exclusion from capital gain for personal residences under IRC з121. Section 121 permits an exclusion from capital gain realized of $250,000 for a single person and $500,000 for a married couple on the sale of a home used as a primary residence for any two of the past five years.

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If, however, the residence was acquired as a replacement property in a з1031 exchange, the Exchanger must have held the property for a total of five years before it qualifies for the з121 capital gain exclusion on sale. IRC з1031 permits the deferral of capital gain realized by exchanging property held in a trade or business or for investment for like-kind investment or business use property of equal or greater value. Obviously, the ExchangerТs principal residence will not qualify for a з1031 exchange, but if, for example, the residence is converted for use as a rental for two years, it may qualify both for a з1031 exchange as property used in a trade or business and also for the з121 exclusion when it is sold. On February 4, 2005 the IRS issued Revenue Procedure 2005-14 providing guidance on the concurrent application of IRC з121 and з1031. Naturally, consultation with a tax advisor is important whenever an Exchanger changes how they intend to hold property.

Can I take a з121 Exclusion and do a з1031 exchange on the same property?

Rev. Proc. 2005-14
This rev proc provides guidance on the application of зз121 and 1031 to the single exchange of property.

Example:
Taxpayer buys home for $210,000, uses it as principal residence from 2000-2004; 2004-2006 TP rents house to tenants and starts depreciation on the property.
2006 TP sells house for $490,000. TP realizes gain of $280,000.
TP can use the з121 exclusion for $250,000 of the gain, and also do a з1031 exchange for $30,000

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