First American Title: Real Estate Solutions™

A Message from the 2005 S.E.C. Corporate Sponsor

New Revenue Procedure 2005-14 Clarifies Treatment of Gain for Properties Used as a Personal Residence and for Investment Purposes

Many taxpayers hold property both for business and personal uses. A taxpayer may live in a house for several years and then move out of the house and rent it, or may rent a house for a number of years and then use it as a personal residence. A concurrent personal and business use is also possible. For example, a taxpayer may own a duplex and rent one unit and live in the other unit. Some taxpayers use a portion of their personal residence as an office, whether it is located in the same building as the personal residence or in a separate building on the same lot as the personal residence.

All of these possibilities raise the question of how and to what extent a taxpayer can benefit from the exclusion of gain provisions of IRC Section 121, which apply to a personal residence, and the deferral of gain provisions of IRC Section 1031, which apply to property used for investment or for the taxpayer’s trade or business.

Existing Law

Section 121 allows a taxpayer to exclude up to $250,000 of gain ($500,000 for married taxpayers filing jointly) on the sale or exchange of a personal residence, provided that the taxpayer has owned and used the property as a personal residence for a total of at least two years during the preceding five year period. Under existing Treasury regulations, a taxpayer that uses one building for personal and business uses may qualify the entire building for deferral of gain under Section 121 if the taxpayer has used only a portion of it for personal use for the required two year period. If the taxpayer’s office is located in a separate building such as a guest house, the Section 121 exclusion of gain will not apply to the guest house unless it qualifies on its own, i.e., the taxpayer used it as a personal residence at least two of the past five years. The exclusion of gain under Section 121 for dual use properties does not exclude gain attributable to recapture of depreciation, however.

Section 1031 allows a taxpayer to defer gain (including gain attributable to recapture of depreciation) on the exchange of property used for investment purposes or for use in the taxpayer’s trade or business. A taxpayer may benefit from the deferral of gain if a portion of the property is used for investment or business purposes and a portion is used for personal use, but the deferral of gain applies only to that portion used for investment or business purposes.

New Revenue Procedure

On January 27, 2005, the IRS issued Revenue Procedure 2005-14, which clarifies how a taxpayer can apply both Section 121 and Section 1031 to exclude and defer gain for the same property, when that property is or has been used for both personal and business use.

Revenue Procedure 2005-14 accomplishes several things.

First, it confirms that taxpayers who qualify for the benefits of both IRC Section 121 and IRC Section 1031 for the same property may benefit from both the exclusion of gain under Section 121 and the deferral of gain under Section 1031.

Second, the Revenue Procedure states that the exclusion of gain under Section 121 is to be applied prior to applying deferral of gain under Section 1031. For example, a single taxpayer using one building for both personal and business use can exclude up to $250,000 of gain, not including gain attributable to depreciation recapture, before any gain is considered for deferral under Section 1031.

Third, the Revenue Procedure states that gain attributable to depreciation may be deferred under Section 1031 for these dual use properties. In other words, although gain attributable to recapture of depreciation cannot be excluded under Section 121, it can be deferred under Section 1031 for dual use property.

Fourth, for property used as a personal residence and for investment, cash or other non-like kind property, i.e., boot, received by the taxpayer is taken into account when computing gain only to the extent the boot exceeds the amount of gain that is excluded under Section 121.

Fifth, the Revenue Procedure provides guidance regarding how to compute the basis of an investment property that is acquired (i.e., replacement property) as a result of an exchange of dual use property. The basis of the replacement property is increased by any gain that was excluded under Section 121 with respect to the relinquished investment property.

Finally, the Revenue Procedure includes six examples that clarify how to apply the rules. Example 1 explains how to compute the gain when a taxpayer uses a house for his personal residence for four years, rents it for two years, and then exchanges it for property to be held for investment purposes. Other examples discuss the computation of gain when a taxpayer uses one building concurrently as a home and office, or uses a home as a residence and a separate guest house as an office.

This Revenue Procedure is effective for all sales occurring on or after January 27, 2005, and taxpayers may use it for transactions that occurred in prior tax years, provided that the statute of limitations for claiming refunds for such prior tax years has not expired. Taxpayers should also note that in 2004, Section 121 was revised to add a five year holding period before gain may be excluded for any properties that were acquired in a Section 1031 exchange and then converted to personal use.

As always, taxpayers should discuss these rules with their tax advisors before selling or exchanging property.

Mary Kay Kennedy
Vice President and Counsel
First American Exchange Company, LLC
1737 N. First Street, Suite 400
San Jose, CA 95112
FAX: 408-451-7955

Comments are closed.