Five Year Combined Hold Period Required to Exclude Gain Under IRC 121

On October 22, 2004, President Bush signed into law corporate and foreign tax legislation that also contained a provision affecting IRC 1031. Under this provision, an Exchanger who performs an IRC 1031 tax deferred exchange into a rental house as replacement property and later the rental house is converted into the Exchangers principal residence, is not allowed to exclude gain under the principal residence exclusion rules of IRC 121 unless the sale occurs at least five years after the closing date of the replacement property purchase. The Conference Agreement on H.R. 4520 includes the following provision to amend 121(d):

Sec. 840. Recognition of gain from the sale of a principal residence acquired in a like-kind exchange within 5 years of sale. (10) PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE -- If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property.

The change to IRC 121 is effective for principal residence sales occurring on or after October 22, 2004 and all investors who previously acquired their current residence through a 1031 exchange within the past three years will now have to wait at least two more years before selling their residence to exclude the gain. This assumes they meet the two out of five year principal residence test.

The result of this additional requirement to IRC 121 is that an investor exchanging into a rental house, which is later converted to a principal residence, will have to wait a minimum of five years to exclude capital gain under IRC 121(subject to the maximum exclusion restrictions of $500,000, married filed jointly; $250,000 filing as a single). Also note that the Exchanger must initially intend to hold the replacement property for investment. There is no defined holding period as to how long a property must be held to be considered held for investment.

AN EXAMPLE

An Exchanger completes an exchange for a rental home that is held for investment and rents the property out for two years. The exchanger decides to move into their former rental house and live it in as their principal residence. Under the new law, the Exchanger will have to wait for at least three years before selling the principal residence and excluding gain under IRC 121.

2. Avoiding paying 3 1/3% withholding tax on sale of rental property

A number of changes were made to this area of the code, but one of the most interesting involves an income property which is sold in California at a profit, and is not involved in a 1031 exchange, then the buyer is required to have 3 1/3% of the purchase price withheld for California taxes. However, effective January 1, 2005, if this income property was the seller's primary residence at the time of sale, they could avoid the payment of the withholding tax.

AN EXAMPLE

A Seller decides he no longer wants to be landlord and wishes to sell a rental home he owns which is worth $500,000. If it is near the beginning of the calendar year, if he sold the now, $16,666 would be subtracted from his proceeds and held by the California Franchise Tax Board until taxes are filed for the year of the sale, which could almost be one year later. Instead, the seller moves in to the property for a few months and plans to sell in the summer to take advantage of possibly higher home prices, and can then avoid the prepayment of the tax.

3. IRS Publication 527(Residential Rental Property, including rental of vacation home)