Tax Advantages of the 1031 Exchange

Two good tools have been brought together to help homeowners save on their taxes: The 1031 exchange applies specifically to investment real estate; and Internal Revenue Code 121 (IRC 121) provides a tax exemption of $250,000 for singles and $500,000 for couples and applies only to the sale of a person’s primary residence.

IRS guidelines allow homeowners, who keep their onetime primary residence as a rental property, to sell that real estate through a 1031 exchange, buy a less expensive home to complete the sale, and pocket the difference tax free because of the IRC 121 exemption.

In the eyes of the IRS, the one-time primary residence turned rental real estate is an investment property in terms of the 1031 exchange, and at the sale is still considered a personal residence in terms of IRC 121 as long as the home was the primary residence for two of the previous five years.

In effect, you can mix the rules on investment second homes and primary residences. The net result is tax-free cash from a real estate exchange.

This process is more than a little convoluted, but it can create a lot of tax-free money when implemented properly.

To look at an ideal example, your primary is residence is worth $200,000, but you’re certain the home is going to appreciate over the next few years. You move out and rent your previous primary residence for two years and sure enough after that period the house is worth $250,000. Using a 1031 exchange you sell the home and buy a lake house for $100,000. Using your IRC 121 exemption the $150,000 difference in the trade is now yours to pocket -- completely tax-free.