1031 Alert: New Tax Legislation Affects Certain Tax-Deferred Exchanges

On October 22, 2004, President Bush signed into law HR 4520. This new law contains a provision which will have a significant impact upon certain tax-deferred exchanges under IRC§1031. It affects taxpayers who acquire, as their replacement properties, rental houses which they later convert to principal residences.

IRC §121 provides that taxpayers may exclude up to $250,000 of gain on the sale of their principal residences ($500,000 for married taxpayers) if they have resided in the property for two of the preceding five years.

Under the new law, taxpayers who convert their replacement properties from rental properties to personal residences now will have to meet an additional requirement in order to exclude all or part of their gain: they must own the replacement property for more than five years before selling it! This provision is effective for sales of principal residence occurring on or after October 22, 2004.

Example: On October 15, 2001, the taxpayer acquired, as replacement property in his tax-deferred exchange, a single family residence ("Blackacre"). On January 15, 2003, the taxpayer converted Blackacre into his principal residence.

Under the old law, the taxpayer would have been eligible to exclude all or a portion of his gain under IRC §121 if he sold Blackacre on or after January 15, 2005 (i.e., two years after moving into it).

Under the new law, the taxpayer cannot exclude his gain from the sale of Blackacre unless he waits until after October 15, 2006, to sell it (i.e., his holding period must exceed five years).

By extending the holding period for principal residences previously acquired in tax-deferred exchanges, this provision will make it less attractive for taxpayers to attempt to combine the benefits of IRC §1031 with those of IRC §121.

(Information acquired from Goodman & Levine LLP, Oakland, California)