Massachusetts Agencies

Gain Exclusion Subject to Five Year Hold Period

Articles from The Massachusetts Focus

Newsletter of Stewart Title Guaranty Company, Massachusetts Offices
Winter 2005, Volume 4, Number 1

Five Year Combined Hold Period Required to Exclude Gain under IRC §121
by Robert "HB" Buckner, Asset Preservation Inc., a Subsidiary of Stewart Title Company

Some taxpayers take advantage of exchanges and the tax deferral available under IRC §1031 and later convert their former rental house to a principal residence to qualify for the tax exclusion available 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 Exchanger's 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, if married and filing jointly; $250,000 if filing as a single person). 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.

Cost Recovery/Deprecation

Capital gain taxes must be paid on the cost recovery ("depreciation") taken after May 6, 1997 (at 25%), but may exclude additional gain on the principal residence, up to the maximum amounts allowed by §121. 

How Long to Rent the 1031 Property?

Section 1031 of the tax code does not provide a defined "holding period" for investment properties. The time period the property is held is only one factor the IRS may look at to determine the taxpayer's intent to hold for investment. The IRS can examine all the other facts and circumstances that may or may not support the intent to hold for investment.

Some legal and tax advisors recommend that a taxpayer hold a 1031 exchange property for a minimum of at least twelve months. The reason for this is that a holding period of twelve or more months results in the taxpayer reflecting the property as an investment property in two tax filing years. Another perspective is holding the 1031 exchange property for at least two years. In one Private Letter Ruling (PLR 8429039), the IRS stated that a minimum holding period of two years was sufficient. Many legal and tax advisors believe two years is a conservative holding period, provided there are no other significant factors to contradict the investment intent. 

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 then have to wait for at least three years before selling the principal residence and excluding gain under IRC §121.