Taxpayer Allowed to Use Both §121 and §1031 in Dispositions for Property Following Fire
The IRS issued a private letter ruling to a taxpayer dealing with both the exclusion of gain on the sale of a residence under IRC §121 and the like-kind exchange provisions of IRC §1031 in PLR 201944006.[1]
The ruling involves a piece of property.
One of the taxpayers had purchased the property to use as a principal residence, and when the taxpayers were married they continued to use it as their principal residence. Eventually the taxpayers moved into a new residence.
The property was then offered to rent. While there was a period of time when the property was rented to full-time tenants, they also rented it for short-term rentals during other portions of this period of time. The rental use ended when the property was destroyed in a fire.
Following the fire the taxpayers received funds for the destroyed residence, sold the land without rebuilding the residence and acquired new property in a transaction they hoped would qualify for deferral of gain under IRC §1031.[2]
The taxpayers asked the IRS to rule on three items:
Did IRC §121 (exclusion of gain of the sale of a principal residence) apply to any of this transaction?
Is it possible for both §121 and §1031 to apply to the same transfer of property?
Was the property they disposed of held for investment for purposes of §1031?
The taxpayers were concerned because there were two sales here—one for the disposition of the building due to the fire and then the later sale of raw land. The ruling notes that §121 can apply to a separate sale of raw land and the remainder of a residence. The ruling notes:
Section 1.121-1(b)(3)(i) addresses when gain from a sale of land is excluded under § 121. Although Taxpayers sale of land is not a sale of vacant land as described in § 1. 121-1(b)(3) (§ 1.121-1(b)(3) addresses the sale of property adjacent to the dwelling unit whereas the land sold by Taxpayers is the actual property on which the dwelling unit was located), it is reasonable to apply those same requirements to a sale of vacant land on which the dwelling unit was actually located. Here, Taxpayers meet the requirements in § 1.121-1(b)(3)(i) on the sale of their land and gain from the sale is excluded as provided in § 121. The destruction of the dwelling unit and subsequent receipt of insurance proceeds in the taxable year before the land sale qualifies as a sale or exchange of the dwelling unit within 2 years of the land sale as described in § 1.121-1(b)(3). In addition, Taxpayers meet the other requirements of § 121 with respect to the land. Taxpayer 1 purchased Property 1 on Date 1 and owned the underlying land until Date 9. Thus, Taxpayer 1 met the ownership requirement under § 121(b)(2)(A)(i) for the land. Both Taxpayers resided on Property 1 as their principal residence from Year 1 until Date 3. Therefore both spouses met the use requirement of § 121(b)(2)(A)(ii) for the land. Finally, Taxpayers assert that neither spouse is ineligible for the benefits under § 121(a) because neither spouse applied § 121 to a sale within two years of the sale of Property 1. The sale or exchange of the dwelling unit and the land, although occurring in different taxable years, are treated as one sale or exchange for purposes of § 121(b)(3). See § 1.121-1(b)(3)(B).
In addition, under § 1.121-1(b)(3)(ii)(A), in applying the maximum limitation amount under § 121 to sales or exchanges of a dwelling unit in one year and land that qualifies for the exclusion under § 121 in a subsequent taxable year, gain from the sale or exchange of the dwelling unit is excluded first. Gain on the sale of the land is then excluded only to the extent of the maximum limitation amount applicable to the taxpayer, minus the gain excluded on the sale of the dwelling unit.[3]
Thus, the ruling concludes that the gain exclusion not yet used following the sale of the residence is available in this case to be used for the sale of the land:
Here, Taxpayers sold the dwelling unit on Property 1 in Year 2 and sold the land on which the dwelling unit was located before its destruction on Date 9. Therefore, the gain excluded under § 121 on the sale of the land is the difference between the maximum limitation amount applicable to Taxpayers and the gain excluded under § 121 in the Year 2 sale of the dwelling unit.[4]
The ruling also points out that the IRS had previously ruled it is possible for both §121 and §1031 to apply to the same transaction:
The issue of whether § 121 and § 1031 may apply to the same transfer of property was addressed in Rev. Proc. 2005-14, 2005-1 C.B. 528. The revenue procedure provides that a transfer of property qualifying for the § 121 exclusion may also qualify for nonrecognition under § 1031, provided that the requirements of § 1031(a) are met with respect to the transfer.[5]
Thus, the IRS also rules:
Taxpayers represent that they held Property 1 as investment property from around Date 5 until Date 9. Therefore, Taxpayers held Property 1 for investment, as described in § 1031(a), prior to its transfer on Date 9. Under Rev. Proc. 2005-14, a transfer of property qualifying for the § 121 exclusion may also qualify for nonrecognition under § 1031, provided all the requirements of § 1031are met with respect to the transfer. The fact that Taxpayers exclude gain under § 121 on the sale or exchange of Property 1, does not preclude them from deferring all or a portion of the remainder of the gain, if any, under § 1031.[6]
While the ruling doesn’t explain the exact method to be used for such reporting, Rev. Proc. 2005-14 itself provides the mechanics of recording such a combined §121/§1031 transaction. Section 4.02 of that procedure provides:
.02 Computation of gain.
(1) Application of § 121 before § 1031. Section 121 must be applied to gain realized before applying § 1031.
(2) Application of § 1031 to gain attributable to depreciation. Under § 121(d)(6), the § 121 exclusion does not apply to gain attributable to depreciation deductions for periods after May 6, 1997, claimed with respect to the business or investment portion of a residence. However, § 1031 may apply to such gain.
(3) Treatment of boot. In applying § 1031, cash or other non-like kind property (boot) received in exchange for property used in the taxpayer's trade or business or held for investment (the relinquished business property), is taken into account only to the extent the boot exceeds the gain excluded under § 121 with respect to the relinquished business property.
.03 Computation of basis. In determining the basis of the property received in the exchange to be used in the taxpayer's trade or business or held for investment (the replacement business property), any gain excluded under § 121 is treated as gain recognized by the taxpayer. Thus, under § 1031(d), the basis of the replacement business property is increased by any gain attributable to the relinquished business property that is excluded under § 121.[7]