Marcel purchased a house in Las Vegas for $210,000, and lived there from 1999 until 2003. Then he moved to Los Angeles, settled into a relationship and bought a new house, where he now lives. Meantime, Marcel is renting out his him in Las Vegas, and claims depreciation deductions of $20,000. Realizing he wants to invest near home, he does a 1031 exchange, paying $460,000 for a loft in downtown L.A. that he is going to lease out. He takes $10,000 in cash from the deal to feed his hobbies.
Since Marcel's adjusted basis is $190,000 ($210,000 - $20,000 in depreciation deductions), he realizes a gain of $280,000. Marcel applies the primary residence rule (Section 121) first to exclude $250,000 of the $280,000 gain before applying the non-recognition rules of Section 1031. He may defer the remaining gain of $30,000, including the $20,000 attributable to depreciation, under Section 1031.
Marcel recognizes no gain for the $10,000 boot because boot is taken into account only to the extent it exceeds the amount of the gain excluded under Section 121. Marcel's basis in the replacement property is $430,000, which is equal to the basis of the relinquished property at the time of the exchange ($190,000) increased by the gain excluded under Section 121 ($250,000), and reduced by the cash Marcel receives ($10,000).
The terms of this new ruling state that you first apply as much of the gain as you need to maximize the Section 121 gain, with the balance applied to the Section 1031 gain.
Traditionally, if a seller received cash or property that is not like-kind property (boot) in an exchange that otherwise qualifies as a like-kind exchange, the taxpayer is required to pay capital gains tax on the boot.
Prior to this current IRS ruling, the like-kind exchange rules did not apply to property that is used solely as a personal residence.
Another new and exciting aspect of this new rule is that property owners can use this exclusion once every two years. This a beneficial if you are confident that your home is going to rapidly appreciate in the next few years and, you can afford to use your family home as a rental property. (Perhaps its time for that sabbatical in Europe?)
If you can afford to keep your primary residence as a rental – and you feel you neighborhood is going to appreciate - speak with your tax advisor about the new guidelines.
* Jodi Summers’ column Days on the Market runs every Wednesday in the Santa Monica Daily Press.