Making a Residential Exchange

Laws cover the exchange of a residential property that's later converted for use as a personal residence.

• You can exclude up to $250,000 ($500,000 for married couples filing jointly) of gain realized on the sale of a principal (primary) residence if you’ve owned and occupied the residence for 2 of the 5 years before the date of sale.
• Gain related to depreciation deductions taken on the property since May 6, 1997 can’t be excluded.

The exclusion doesn’t apply to gain from the sale of the residence that’s allocable to periods of “nonqualified use”—times the property isn’t used as the taxpayer’s principal residence, or its use as a second home or as a rental.

1031 Exchange Real Estate Planning and Allocation Rules

Suppose you exchange to a residence, rent it for 4 years, and then move into it and live in it for 2 years. You then sell the residence and realize $300,000 of gain.

• Your exclusion is prorated (example does not account for depreciation taken after May, 1997, which is taxable):
  • Four-sixths (4 out of 6 years) of the gain, or $200,000, is ineligible for the $250,000 personal residence exclusion.
  • Two-sixths (2 out of 6 years) of the gain, or $100,000, is eligible for the personal residence exclusion.

Allocation Rules and Primary Residence Use

In general, allocation rules apply only to time periods prior to conversion to a principal residence and not to periods after the conversion. So, if you convert a primary residence to a rental, never move back in and otherwise meet the 2 out of 5 year test under Section 121, you’re eligible for the full $250,000 exclusion when you sell the rental.

This rule applies only to nonqualified use periods within the 5 year look-back period of Section 121(a) after the last date the property is used as a principal residence. Therefore, if you use the property as a principal residence in year 1 and 2, rent the property for years 3 and 4, and then use it as a principal residence in year 5, the allocation rules apply and only 3/5 (3 out of 5 years) of the gain is for the exclusion.