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Five Year Hold Required to Exclude Gain Under IRC §121
On October 22, 2004, President Bush signed into law corporate and foreign tax legislation that also contained a provision affecting IRC §1031. Under this provision, a taxpayer who exchanges under IRC §1031 into a rental house as a replacement property that is later converted into their primary residence, is not allowed to exclude gain under the principal residence exclusion rules of IRC §121 unless the sale occurs at least five years from the date of its acquisition. The Conference Agreement on H.R. 4520 includes the following provision to amend §121(d):
Sec. 840. Recognition of gain from the sale of a principle residence acquired in a like-kind exchange within 5 years of sale.
(10) PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE.--If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property.
The result of this additional requirement to IRC §121 is that anyone exchanging into a rental which they subsequently convert to personal use will have to wait at least five years from acquisition before they can sell it as their residence and exclude any gain under IRC§121(a).
The change to the home seller rules of IRC §121 became effective for principal residence sales occurring on or after October 22, 2004. Any taxpayer who previously acquired their current residence through a tax deferred exchange within the past three years will now have to wait at least another two years before selling their home and excluding gain. This assumes they meet the two out of five year occupancy test.
Example: A taxpayer sold their rental house two years ago, completed a simultaneous exchange, and moved there last month to occupy it as their principal residence. Under the new law, they will have to wait three years before selling the property and excluding gain under IRC §121.
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