IRS ISSUES GUIDANCE FOR EXCHANGES INVOLVING PRINCIPAL RESIDENCES

Revenue Procedure 2005-14

January 27, 2005

On January 27, 2005, the IRS released its long anticipated revenue procedure detailing the application of both IRC §121 and IRC §1031 to a single exchange of property.   Revenue Procedure 2005-14 applies to all transactions occurring on or after January 27, 2005, and to any transaction occurring in a year in which the statute of limitations has not expired.

IRC §121 provides for an exclusion of gain on the sale of a principal residence under certain qualifying circumstances.  IRC §1031 provides for the deferral of gain upon the exchange of trade, business or investment property under certain qualifying circumstances.  This revenue procedure recognizes that a single disposition of property could qualify under both of these sections and provides rules to govern their interrelationship by analogy to the portions of IRC §121 dealing with IRC §1033 transactions.

Under this revenue procedure:

1.  Gain is excluded under IRC §121 first and then any remaining gain is eligible for deferral under IRC §1031;

2.  Post-May 6, 1997, depreciation taken on a principal residence is eligible for deferral under IRC §1031;

3.  Boot is recognized only if received in an amount in excess of the gain deferral under IRC §121; and

4.  Basis in the replacement property is calculated by treating the excluded gain as if it had been recognized.

These rules are illustrated in Revenue Procedure through six (6) useful and comprehensive examples.  Example 1 deals with a situation in which a former principal residence has been converted into a rental property and then exchanged for a small amount of cash and a replacement rental property.  Example 1 clearly allows the application of the IRC §121 gain exclusion to this transaction with IRC §1031 applying to any remaining gain.

Examples 2 through 6 involve a mixed use property (one used concurrently as a principal residence and for business purposes) that is exchanged for a new principal residence and a new replacement business property.  These five (5) mixed use examples cover a variety of slightly different factual situations in order to highlight their different tax results.  Example 2 should be noted as representing a slightly different factual pattern from the others.  In Example 2, the mixed use property consists of separate buildings – one used as a principal residence and the other for business purposes.  As a result, the gain attributable to the separate business use building is not eligible for the IRC §121 gain exclusion.