1031 Exchange

1031 Exchange Questions

121 Exclusions and deferred gains

My parents originally owned House A, a long-term rental they sold in 2024. They did a 1031 exchange and used the proceeds to buy two replacement rental properties: House B and House C.

They’ve been renting both houses since early 2025. The plan is for them to move into House B after 2-ish years, live there for at least 2 out of 5 years, and then potentially sell House B.

Question 1: If they live in house B for 2 out of the 5 years since purchase, would they get the  121 primary residence exclusion when selling?

Question 2: If they sell only House B, do they owe tax on the entire deferred gain from House A? Or do they only owe tax on House B’s share of the deferred gain, with House C’s share remaining deferred until House C is sold?

Below is the clean, accurate IRS-compliant explanation for BOTH parts of your question. This involves the interaction of §1031 deferred gain, §121 primary residence exclusion, and basis allocation rules when one relinquished property (House A) is exchanged into multiple replacement properties (House B and C).

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✅ Question 1: Can House B qualify for the §121 Primary Residence Exclusion?

Short answer: Yes — but with two big limitations.

They can use the §121 exclusion when selling House B after legitimately converting it to a primary residence and living in it for 2 of the 5 years before sale.

BUT they will not receive the full exclusion because:

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Limitation 1 — “Nonqualified Use” Rules (IRC §121(b)(4))

Any period after 2008 during which the property was used as a rental before it became the primary residence is considered “nonqualified use.”

That portion cannot be excluded under §121.

Example numbers:

• They rent House B from 2025–2027 → 3 years nonqualified use

• Then live there 2027–2029 → 2 years qualified use

If they sell in 2029, only this fraction of gain is excludable:

\text{Excludable gain} = \text{Total gain} \times \frac{\text{Qualified use (2 years)}}{\text{Total ownership (5 years)}}

So only 2/5ths of the gain is eligible for exclusion.

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Limitation 2 — Depreciation Recapture Is ALWAYS Taxable

They must pay tax on all depreciation taken (or required to be taken) during the rental period — even if §121 applies.

This recapture is taxed at up to 25%.

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👉 Conclusion for Q1

Yes, they can get a partial §121 exclusion for House B — never the full exclusion — and depreciation recapture is always taxable.

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✅ Question 2: If they sell only House B, do they owe tax on ALL deferred gain from House A? Or just House B’s share?

They owe tax ONLY on House B’s share of the deferred gain.

When a single relinquished property is exchanged into multiple replacement properties:

➜ The deferred gain must be allocated between House B and House C at the moment of the exchange.

Allocation is typically based on:

• Fair Market Value (FMV) of each property at acquisition

• OR equity/value proportion acquired using the 1031 exchange proceeds

This is exactly how tax basis works inside a multi-property 1031.

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✔️ “Deferred gain” follows the property, not the taxpayer.

So:

• When House B is sold → tax becomes due only on the deferred gain allocated to House B.

• The deferred gain allocated to House C remains fully deferred until House C is sold.

This is similar to having two separate “1031 basis buckets.”

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Example (simple numbers)

House A:

• Basis: $200,000

• Sale Price: $600,000

• Deferred gain: $400,000

Exchange into:

• House B FMV: $300,000

• House C FMV: $300,000

Deferred gain is split 50/50:

• House B gets $200,000 deferred gain

• House C gets $200,000 deferred gain

If House B is sold later:

• Recapture all depreciation taken on B

• Recognize only the $200,000 deferred gain assigned to House B (minus any §121 exclusion amount)

• House C’s $200,000 stays deferred until C is sold

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👉 Conclusion for Q2

They do not trigger recognition of ALL the gain from House A.

They trigger recognition of only the deferred gain allocated to House B.

House C’s gain stays deferred.

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✅ Summary

Question	Answer
1. Can House B receive the §121 exclusion after 2 years of primary residence?	Yes, but only a partial exclusion because of nonqualified rental use, and depreciation recapture is always taxable.
2. If they sell only House B, do they owe tax on all deferred gain?	No. Only on the deferred gain allocated to House B. House C keeps its deferred gain until sold.