The two provisions
Section 121 can allow an individual to exclude a limited amount of gain on the sale of a principal residence when ownership and use requirements are met — generally owning and using the home as a principal residence for at least two of the five years before the sale, subject to numerous conditions and limits.
Section 1031 applies to real property held for investment or business use, and defers rather than excludes gain. A principal residence does not qualify for Section 1031 while it is being used as a residence.
A property that was a home and later became a rental can sit at the intersection. Revenue Procedure 2005-14 addresses situations where both provisions may apply to a single transaction, with ordering rules and limitations. Whether it helps you depends entirely on your dates, your use history and your numbers.
Where owners get tripped up
- Nonqualified use. Periods of non-residential use after 2008 can limit the portion of gain eligible for exclusion. Many owners assume the full exclusion still applies.
- Depreciation. Depreciation claimed or allowable during the rental period is generally not excludable under Section 121 and may be recognized.
- The two-of-five clock. It keeps running. Owners who move out and rent long-term can lose eligibility while waiting to decide.
- Converting a replacement property later. Converting property acquired in an exchange into a residence involves additional holding-period rules and limits on later exclusion. Plan it in advance, not afterward.
Primary sources