Reporting an Exchange of Dual‑Use Property

The following documents are available for download.

Download Revenue Procedure 2005-14 (pdf).

Download Examples of How IRC §121 and §1031 Combine for Sales of Combination and Dual-Use Residential/Business Use Properties (pdf).

IRS Issues Guidance On How To Report Exchange Of Property Used For Residential And Business Use (Rev Proc 2005-14)

Revenue Procedure 2005-14 provides guidance on tax reporting issues under IRC §121 and §1031 for exchanges of property that are combination or dual-use residential and business/ investment property.

Background - A homeowner can exclude up to $250,000 ($500,000 on a joint return) of gain from the sale or exchange of a home if he owned and used the property as his principal residence for at least 2 of the 5-years preceding the date of sale (IRC §121). However, any depreciation taken on the property since May 6, 1997 is not eligible for the exclusion.

Treasury Regulation 1.121-1 issued in 2002 made it clear that the IRC §121 exclusion of gain on the sale of a personal residence applies to an entire structure that is used partly as a personal residence and partly for business or investment use.

The business/investment portion of a combination or dual-use residential property is eligible for tax deferral under IRC §1031. Accordingly, residential property may be eligible for exclusion or tax deferral under both provisions of the Internal Revenue Code simultaneously.

Revenue Procedure 2005-14 gives six examples of how to report exchanges of property eligible for exclusion under IRC §121 and §1031 in varying circumstances that can be summarized by the following examples. For purposes of these examples, assume the taxpayer is single and eligible for a gain exclusion of $250,000 under IRC §121.

Rental Property Now, Personal Residence in a Prior Year. IRC §121 does not require a taxpayer to be residing in a residence at the date of sale in order to qualify for the gain exclusion. If the taxpayer owned and lived in a residence in two out of the past five years, it is eligible for gain exclusion under IRC §121 even if it is presently being used as a rental. The taxpayer can exclude gain up to $250,000 under IRC §121 except for any depreciation taken on the property since May 6, 1997. Gain resulting from depreciation is eligible for tax-deferral under IRC §1031. Realized gain is first excluded under IRC §121 and then deferred under IRC §1031. Cash boot of up to $250,000 received on the exchange would be tax-free under §121 even though the residence is currently being used as a rental property. Basis in the replacement property is increased by any gain excluded under IRC §121 in excess of cash received under IRC §121. This can get tricky, see Rev. Proc. 2005-14 for specifics.

Combination Property, Two Structures on Same Property. If a taxpayer owns a property with a residence on it and a second structure used for business purposes, the property is a combination property. Part of the property is eligible for gain exclusion under IRC §121 and part of the property is eligible for tax-deferral under §1031. The exchange has to be accounted for as if there were two properties being exchanged. The proceeds of sale has to be allocated between the §121 amd §1031 property. The value of the replacement property has to be allocated between personal and business uses and realized gain is measured separately for each property. If the exchange of the business use of the relinquished property for business use replacement property results in a trade-down, there will be taxable boot on the exchange of the business portion of the relinquished property. Gain attributable to the business portion of the relinquished property cannot be excluded under IRC §121 or vice versa. §121 realized gain in excess of the $250,000 exclusion cannot be sheltered by tax-deferral under the §1031 portion of the property. Basis in the replacement property is measured separately for the personal residence and business portions of the property under the normal rules.

Dual-Use Property, One Structure Used Partly for Residential and Business Uses. Any gain resulting from cash or debt reduction boot realized on the exchange will be tax-free up to $250,000 under IRC §121 even if the gain is allocable to or results from a trade-down on the business portion of the relinquished property. That is, except for any depreciation taken on the relinquished property since May 6, 1997. Variations on this theme can be summarized as follows —

• As with Combination Property (see above) you have to imagine that dual-use property consists of two properties; §121 property and §1031 property.
• Cash (or debt reduction) boot received on the exchange is tax-free under IRC §121 up to a maximum of $250,000, even if it relates to the 1031 portion of the property.
• Depreciation taken on the property that is allocable to the 1031 portion of the property can be tax-deferred under §1031. Depreciation taken on the §121 portion of the property since May 6, 1997 is taxable and cannot be sheltered by IRC §1031.
• Gain on a §1031 exchange allocable to the personal residence portion of the property in excess of $250,000 is taxable under IRC §121 and cannot be sheltered under IRC §1031.
• If a taxpayer is doing a 1031 exchange of a dual-use residence, taxpayer can elect to "take" a §121 gain exclusion on the exchange even though he received no boot from the exchange. In this case, the taxpayer receives a step-up in tax basis on the replacement property attributable to the §121 gain exclusion.

Revenue Procedure 2005-14 does not address closing issues on exchanges of property used partly for residential purposes and partly for investment/business uses. Treasury Department Publication 523 (1998 - now replaced by new Pub. 523) instructed taxpayers with Dual-Use Property to treat the sale as the sale of two properties. Intermediaries frequently separated an exchange of dual-use property in a similar manner with separate settlement statements so that the taxpayer could cash-out on the personal residence part and roll the 1031 part thru an exchange. As a result of Rev Proc 2005-14, this will no longer be necessary for Dual-Use Property. It remains a good idea for sales of Combination Property.