The interaction of §121 (exclusion of gain on the sale of a principle residence) and §1031 (non-recognition of gain or loss in like-kind exchanges) has long been the subject of confusion for taxpayers. Recently, the Internal Revenue Service issued Revenue Procedure 2005-14, providing clear guidance on this issue.

Section 121(a) provides that a taxpayer may exclude gain realized on the sale or exchange of property, if the property was owned and used as the taxpayer’s principal residence for at least 2 of the preceding 5 years. Section 121(b) provides generally that the amount of the exclusion is limited to $250,000 ($500,000 for certain joint returns). Section 121(d), as amended by the American Jobs Creation Act of 2004, Pub. L. 108-357, provides that, for sales or exchanges commenced after October 22, 2004, taxpayers who acquired property in an exchange to which § 1031 applied, must hold the property for five years from the acquisition date before they may apply the § 121 exclusion.

Section 1031(a) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment (relinquished property) if the property is exchanged solely for property of like kind (replacement property) that is to be held either for productive use in a trade or business or for investment. Under § 1031(b), gain must be recognized, however, to the extent that the taxpayer also receives cash or property that is not like-kind property (boot) in an exchange that otherwise qualifies under § 1031(a).

Revenue Procedure 2005-14, issued February 14, 2005, "applies to taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the exchange of a principal residence under § 121 and the nonrecognition of gain on the exchange of like-kind properties under § 1031." The Revenue Procedure applies only to taxpayers who satisfy the 'held for productive use in a trade or business or for investment' requirement of § 1031(a)(1) with respect to both the relinquished business property and the replacement business property.

Since neither §121 nor §1031 addresses the application of both sections to the exchange of a single piece of property, this Revenue Procedure was necessary to provide guidance to taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the exchange of a principal residence under § 121 and the nonrecognition of gain on the exchange of like-kind properties under § 1031.

To garner the benefits of both §121 and §1031, new rules must be followed:

(1) Application of § 121 before § 1031. Section 121 must be applied to gain realized before applying § 1031;

(2) Application of § 1031 to gain attributable to depreciation. Under § 121(d)(6), the § 121 exclusion does not apply to gain attributable to depreciation deductions for periods after May 6, 1997, claimed with respect to the business or investment portion of a residence. However, § 1031 may apply to such gain; and

(3) Treatment of boot. In applying § 1031, cash or other non-like kind property (boot) received in exchange for property used in the taxpayer’s trade or business or held for investment (the relinquished business property), is taken into account only to the extent the boot exceeds the gain excluded under § 121 with respect to the relinquished business property.

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