7856 / How is the exclusion for gain on the sale of a principal residence coordinated with the like-kind exchange rules?

If a taxpayer acquires property in a like-kind exchange under which gain is not recognized (in whole or in part) by the taxpayer under IRC Sections 1031(a) or 1031(b), the exclusion of gain under IRC Section 121(a) does not apply to the sale or exchange of such property by the taxpayer (or by any person whose basis in the property is determined, in whole or in part, by reference to the basis in the hands of the taxpayer) during the five-year period beginning with the date of the acquisition.¹

The Service and the Treasury Department have released guidance on how to handle a like-kind exchange of a home taking into account IRC Section 121 (home sale gain exclusion) and IRC Section 1031 (like-kind gain deferral).² The revenue procedure clarifies that a homeowner who may exclude gain upon a sale or exchange of a home may also benefit from a deferral of gain for a like-kind exchange with respect to the same property.

IRC Section 1031 provides that in the case of business or investment property (with some exceptions), a property owner generally would not recognize gain upon the exchange of the property for replacement property of a like kind.³ The property owner would recognize any gain to the extent received in cash or property that is not of a like kind (“boot”)⁴ (see Q 7838 and Q 7839). Property used solely as a home would not constitute business or investment property for these purposes, and an exchange of such property would therefore be ineligible for nonrecognition under IRC Section 1031.

The revenue procedure indicates that a homeowner may benefit from both the home sale exclusion and the like-kind deferral in cases where the property has been used consecutively or concurrently as a home and a business (e.g., rental residence). The basic rules for applying these statutory provisions are as follows:

(1) When computing gain, IRC Section 121 must be applied to the realized gain before applying IRC Section 1031.

(2) Although IRC Section 121 does not apply to gain attributable to depreciation deductions that have been claimed with respect to the business or investment portion of a residence, IRC Section 1031 may apply to such gain.

(3) When “boot” (i.e., cash or other property not of a like kind) is received in exchange for relinquished business property, the boot is taken into account only to the extent that it exceeds the gain excluded under IRC Section 121 with respect to the relinquished business property.

(4) When computing the basis of the replacement business property, any gain excluded under IRC Section 121 is treated as gain recognized by the taxpayer. Thus, the basis of the replacement business property is increased by any gain attributable to the relinquished business property excluded under IRC Section 121. Several examples are provided in the revenue procedure.⁵