Category: 1031 Exchange General

Seller financing comes up most frequently where the seller is the taxpayer under an exchange, and the taxpayer is providing some seller financing to the buyer. However, it can also come up where the taxpayer is receiving seller financing from the seller of the replacement property.
What is seller financing?
Seller financing occurs when a person selling real estate is willing to let the purchaser pay the purchase price over time. This can be done for a wide variety of reasons such as the buyer cannot qualify for a conventional loan, or the economics of the deal require a lower interest rate compared to an outside lender. In this case the seller “holds the paper” requiring the taxpayer to pay the seller over time on specified terms. In general, it will also allow the seller to report the income from the periodic payments in the year in which they are received rather than all in the year of an outright sale.
How does seller financing work?
Seller financing can be structured in a couple of ways. One allows the buyer to receive title to the property at the time of closing and the other allows the buyer to take title upon payment of the last installment. More specifically, the first way would be documented with a promissory note from the buyer to the seller. This note would specify the interest rate, the length of time over which the loan was amortized, and the monthly payment amount. The note would typically be secured by a mortgage in favor of the seller as a lien against the property. In some jurisdictions the security interest used may be referred to as a trust deed or deed of trust.
The second way of documenting the transaction would entail some kind of installment contract between the parties. Again, there are regional differences regarding the name of that contract. It can be called an Installment Agreement for Deed or a Contract for Deed or Articles of Agreement for Deed. For tax and exchange purposes they are all the same. Generally, there would be some money paid down from the buyer to the seller and the balance financed over time. Sometimes it will be paid off at the time of the last fixed payment and in other instances it has a balloon payment for the final lump sum.
Whether the transaction is documented by a deed transfer at the time of the initial closing and secured by a note and mortgage or the deed passing upon final payment the tax treatment is the same. The buyer still owns the property either way, but subject to all payments being made. An analogy can be made to buying a new car with some dealer financing. In the case of an installment contract, the buyer owns the car but will not get clear title until it is paid off.
Regardless of the structure, the documents should show the funds payable to the Qualified Intermediary. Funds paid to the taxpayer would constitute “boot” and therefore taxable.
How does seller financing work with an exchange if the taxpayer is financing the buyer?
This can be a bit tricky. For §1031 purposes, a taxpayer only has 180 days from the date of sale of the relinquished property to acquire the replacement property. For there to be total tax deferral, the full value of the sale property must be reinvested into the replacement property. But when seller financing is involved, the seller does not have the full value to roll over. There are times when the full value will be paid into the exchange account within the 180 day window but more often than not, it will be paid after the 180 day exchange period. So, payments coming into the exchange account can be used towards the acquisition of replacement property, but funds payable after that 180 day term cannot.
Although there are various ways to deal with this, the most common one is for the seller to “advance” the balance due for the replacement property with personal funds. Those funds can come from the taxpayer directly or can be borrowed by the taxpayer. The exchange balance plus the additional funds are used to acquire the replacement property. The note and mortgage or the installment sale agreement is then assigned from the Qualified Intermediary to the taxpayer. Since the necessary value was invested on a timely basis into the replacement property, the receipt by the taxpayer of principal payments over time under the financing document are not taxable.
How does seller financing work with an exchange if the taxpayer is receiving financing from the Seller?
This situation is not as complicated as when the taxpayer is financing the buyer. In any exchange, in order to have complete deferral, a taxpayer has to reinvest all the net proceeds from the sale and have equal or greater new debt compared to debt paid off at the relinquished property closing. Debt in the form of the balance due under the seller financing structure counts just like conventional financing, so it would typically offset the debt requirement to have equal or greater debt on the replacement property.
In summary, seller financing is a part of many real estate transactions. However, due to the rules around §1031 exchanges, some special steps need to be taken on account of the seller financing. If the taxpayer is selling, the loan must be documented so that the exchange company is the payee of the loan, and the applicable security interest should correspond. Once the loan document is monetized from a cash infusion by the taxpayer, the necessary amount can be exchanged into the replacement property. Ultimately, the security interest is assigned to the taxpayer and the taxpayer will not recognize any tax on the principal received over time due to the advancement of the funds at the time of the exchange. In the event the taxpayer is receiving the seller financing in connection with the purchase of the replacement property, such debt obligation is treated no differently than any other loan from a conventional financing source. The seller financing debt will offset debt paid off upon closing of the relinquished property.

Generally speaking, capital gains are any profits generated from the sale of assets. Further, people often refer to Section 1031 Exchanges as Tax Deferred Exchanges or Tax-Free Exchanges. The key language of the statute says that “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” On its face, the statute is a tool to defer capital gains taxes, not to avoid capital gains taxes.
What is Capital Gains Tax?
Capital gains tax is the tax that American taxpayers (both US citizens and non-citizens) pay on any profits (capital gains) generated from the sale of assets. Those assets include real estate, investments such as stocks, and businesses, among others. According to the IRS, those gains are to be considered taxable income. The IRS has different tax rates for capital gains based on the taxpayer’s income tax bracket, as well has how long the asset was held.
Are There Variations of Capital Gains Tax?
Assets that the taxpayer held for longer than one year result in long-term capital gains, while assets held for less than one year result in short-term capital gains. The Internal Revenue Code treats short-term capital gains the same as any other ordinary income so that the tax rate is the same as your income tax rate. Long-term capital gains at more favorable rates, as shown below.
For 2022, the tax brackets look like this:

How is Capital Gains Tax Calculated?
Generally speaking, if an asset is sold for more than its purchase price (it’s “cost basis”), there is a capital gain. On the other hand, if it is sold for less than it’s purchase price, there is a capital loss. But the Internal Revenue Code makes things a little more complicated, and calculates gain or loss based on the asset’s “adjusted basis.” To arrive at the adjusted basis, the taxpayer will start with the cost basis, and then add the cost of capital improvements, and subtract any depreciation taken. Note that only improvements to real estate can be depreciated, and the value of the land itself never depreciates. Use our Depreciation Calculator. 
To determine the final capital gains tax burden, the taxpayer would start by calculating the adjusted basis as described above, and subtract that from the current sale price; the difference is the capital gain. If the asset was held for longer than one year, the gain would be taxed according to the last column in the table above. If the asset was held for less than one year, the gain would be taxed as ordinary income based on the third column. Use our Capital Gains Calculator.
How Does Section 1031 Help with Capital Gains Taxes
As noted above, Section 1031 provides that the gain on the exchange of an asset is not recognized in the year of the sale. Under the Internal Revenue Code, those gains are deferred, and will only be recognized at a time in the future when there is a taxable sale rather than another exchange.
A taxpayer can structure a transaction as a 1031 exchange in 2022, exchange that asset in 2025, exchange again in 2030, exchange again in 2032, and so on. Doing so would continue to defer the gains that accumulate between each sale. If that taxpayer ultimately sells the final asset in 2040, all of the deferred gains from each of those intervening 1031 exchange would be recognized.
But if the taxpayer is going to pay taxes at the end anyway, why exchange in the first place? There are two primary reasons that the taxpayer would structure those exchanges and then ultimately sell in a taxable transaction. First is the time value of money. Simply stated, the time value of money is the concept that a dollar today is worth more than a dollar tomorrow. Ask yourself this – would you rather pay someone $10,000 today, or ten years from now? Most investors would rather pay in ten years rather than today, preferably never if possible. The second reason is that theoretically, a taxpayer will sell their last investment property later in life, perhaps when they have past their peak earning years and are in a lower tax bracket. A married couple reducing their income from $650,000 to $200,000 would see their capital gains rate drop from 20% to 15% – a 25% reduction in the tax rate.
Can Section 1031 be Used to Eliminate or Avoid Capital Gains Tax
Using the scenario above, a taxpayer structures a transaction as a 1031 exchange in 2022, exchanges that asset in 2025, exchanges again in 2030, and exchanges again in 2032, before dying in 2035. Based on the Internal Revenue Code, that taxpayer’s heirs would inherit the final property at the fair market value as of the taxpayer’s death, receiving the property at a “stepped up basis.” The heirs do not need to worry about any accumulated depreciation or capital gains that a taxpayer had meticulously avoided through deferral, and they start with completely fresh basis. If the heirs were to sell the property shortly thereafter, there would be no capital gains to recognize.
By continuing to exchange throughout their life, this taxpayer successfully avoided all depreciation recapture and capital gains taxes. They effectively converted a tax deferred exchange into a tax-free exchange.
Section 1031 can be a powerful investment tool, and an incredibly useful estate planning tool. Taxpayers are encouraged to seek the advice of competent tax and legal counsel before structuring any 1031 exchange.

Generally speaking, capital gains are any profits generated from the sale of assets. Further, people often refer to Section 1031 Exchanges as Tax Deferred Exchanges or Tax-Free Exchanges. The key language of the statute says that “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” On its face, the statute is a tool to defer capital gains taxes, not to avoid capital gains taxes.
What is Capital Gains Tax?
Capital gains tax is the tax that American taxpayers (both US citizens and non-citizens) pay on any profits (capital gains) generated from the sale of assets. Those assets include real estate, investments such as stocks, and businesses, among others. According to the IRS, those gains are to be considered taxable income. The IRS has different tax rates for capital gains based on the taxpayer’s income tax bracket, as well has how long the asset was held.
Are There Variations of Capital Gains Tax?
Assets that the taxpayer held for longer than one year result in long-term capital gains, while assets held for less than one year result in short-term capital gains. The Internal Revenue Code treats short-term capital gains the same as any other ordinary income so that the tax rate is the same as your income tax rate. Long-term capital gains at more favorable rates, as shown below.
For 2022, the tax brackets look like this:

How is Capital Gains Tax Calculated?
Generally speaking, if an asset is sold for more than its purchase price (it’s “cost basis”), there is a capital gain. On the other hand, if it is sold for less than it’s purchase price, there is a capital loss. But the Internal Revenue Code makes things a little more complicated, and calculates gain or loss based on the asset’s “adjusted basis.” To arrive at the adjusted basis, the taxpayer will start with the cost basis, and then add the cost of capital improvements, and subtract any depreciation taken. Note that only improvements to real estate can be depreciated, and the value of the land itself never depreciates. Use our Depreciation Calculator. 
To determine the final capital gains tax burden, the taxpayer would start by calculating the adjusted basis as described above, and subtract that from the current sale price; the difference is the capital gain. If the asset was held for longer than one year, the gain would be taxed according to the last column in the table above. If the asset was held for less than one year, the gain would be taxed as ordinary income based on the third column. Use our Capital Gains Calculator.
How Does Section 1031 Help with Capital Gains Taxes
As noted above, Section 1031 provides that the gain on the exchange of an asset is not recognized in the year of the sale. Under the Internal Revenue Code, those gains are deferred, and will only be recognized at a time in the future when there is a taxable sale rather than another exchange.
A taxpayer can structure a transaction as a 1031 exchange in 2022, exchange that asset in 2025, exchange again in 2030, exchange again in 2032, and so on. Doing so would continue to defer the gains that accumulate between each sale. If that taxpayer ultimately sells the final asset in 2040, all of the deferred gains from each of those intervening 1031 exchange would be recognized.
But if the taxpayer is going to pay taxes at the end anyway, why exchange in the first place? There are two primary reasons that the taxpayer would structure those exchanges and then ultimately sell in a taxable transaction. First is the time value of money. Simply stated, the time value of money is the concept that a dollar today is worth more than a dollar tomorrow. Ask yourself this – would you rather pay someone $10,000 today, or ten years from now? Most investors would rather pay in ten years rather than today, preferably never if possible. The second reason is that theoretically, a taxpayer will sell their last investment property later in life, perhaps when they have past their peak earning years and are in a lower tax bracket. A married couple reducing their income from $650,000 to $200,000 would see their capital gains rate drop from 20% to 15% – a 25% reduction in the tax rate.
Can Section 1031 be Used to Eliminate or Avoid Capital Gains Tax
Using the scenario above, a taxpayer structures a transaction as a 1031 exchange in 2022, exchanges that asset in 2025, exchanges again in 2030, and exchanges again in 2032, before dying in 2035. Based on the Internal Revenue Code, that taxpayer’s heirs would inherit the final property at the fair market value as of the taxpayer’s death, receiving the property at a “stepped up basis.” The heirs do not need to worry about any accumulated depreciation or capital gains that a taxpayer had meticulously avoided through deferral, and they start with completely fresh basis. If the heirs were to sell the property shortly thereafter, there would be no capital gains to recognize.
By continuing to exchange throughout their life, this taxpayer successfully avoided all depreciation recapture and capital gains taxes. They effectively converted a tax deferred exchange into a tax-free exchange.
Section 1031 can be a powerful investment tool, and an incredibly useful estate planning tool. Taxpayers are encouraged to seek the advice of competent tax and legal counsel before structuring any 1031 exchange.

Generally speaking, capital gains are any profits generated from the sale of assets. Further, people often refer to Section 1031 Exchanges as Tax Deferred Exchanges or Tax-Free Exchanges. The key language of the statute says that “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” On its face, the statute is a tool to defer capital gains taxes, not to avoid capital gains taxes.
What is Capital Gains Tax?
Capital gains tax is the tax that American taxpayers (both US citizens and non-citizens) pay on any profits (capital gains) generated from the sale of assets. Those assets include real estate, investments such as stocks, and businesses, among others. According to the IRS, those gains are to be considered taxable income. The IRS has different tax rates for capital gains based on the taxpayer’s income tax bracket, as well has how long the asset was held.
Are There Variations of Capital Gains Tax?
Assets that the taxpayer held for longer than one year result in long-term capital gains, while assets held for less than one year result in short-term capital gains. The Internal Revenue Code treats short-term capital gains the same as any other ordinary income so that the tax rate is the same as your income tax rate. Long-term capital gains at more favorable rates, as shown below.
For 2022, the tax brackets look like this:

How is Capital Gains Tax Calculated?
Generally speaking, if an asset is sold for more than its purchase price (it’s “cost basis”), there is a capital gain. On the other hand, if it is sold for less than it’s purchase price, there is a capital loss. But the Internal Revenue Code makes things a little more complicated, and calculates gain or loss based on the asset’s “adjusted basis.” To arrive at the adjusted basis, the taxpayer will start with the cost basis, and then add the cost of capital improvements, and subtract any depreciation taken. Note that only improvements to real estate can be depreciated, and the value of the land itself never depreciates. Use our Depreciation Calculator. 
To determine the final capital gains tax burden, the taxpayer would start by calculating the adjusted basis as described above, and subtract that from the current sale price; the difference is the capital gain. If the asset was held for longer than one year, the gain would be taxed according to the last column in the table above. If the asset was held for less than one year, the gain would be taxed as ordinary income based on the third column. Use our Capital Gains Calculator.
How Does Section 1031 Help with Capital Gains Taxes
As noted above, Section 1031 provides that the gain on the exchange of an asset is not recognized in the year of the sale. Under the Internal Revenue Code, those gains are deferred, and will only be recognized at a time in the future when there is a taxable sale rather than another exchange.
A taxpayer can structure a transaction as a 1031 exchange in 2022, exchange that asset in 2025, exchange again in 2030, exchange again in 2032, and so on. Doing so would continue to defer the gains that accumulate between each sale. If that taxpayer ultimately sells the final asset in 2040, all of the deferred gains from each of those intervening 1031 exchange would be recognized.
But if the taxpayer is going to pay taxes at the end anyway, why exchange in the first place? There are two primary reasons that the taxpayer would structure those exchanges and then ultimately sell in a taxable transaction. First is the time value of money. Simply stated, the time value of money is the concept that a dollar today is worth more than a dollar tomorrow. Ask yourself this – would you rather pay someone $10,000 today, or ten years from now? Most investors would rather pay in ten years rather than today, preferably never if possible. The second reason is that theoretically, a taxpayer will sell their last investment property later in life, perhaps when they have past their peak earning years and are in a lower tax bracket. A married couple reducing their income from $650,000 to $200,000 would see their capital gains rate drop from 20% to 15% – a 25% reduction in the tax rate.
Can Section 1031 be Used to Eliminate or Avoid Capital Gains Tax
Using the scenario above, a taxpayer structures a transaction as a 1031 exchange in 2022, exchanges that asset in 2025, exchanges again in 2030, and exchanges again in 2032, before dying in 2035. Based on the Internal Revenue Code, that taxpayer’s heirs would inherit the final property at the fair market value as of the taxpayer’s death, receiving the property at a “stepped up basis.” The heirs do not need to worry about any accumulated depreciation or capital gains that a taxpayer had meticulously avoided through deferral, and they start with completely fresh basis. If the heirs were to sell the property shortly thereafter, there would be no capital gains to recognize.
By continuing to exchange throughout their life, this taxpayer successfully avoided all depreciation recapture and capital gains taxes. They effectively converted a tax deferred exchange into a tax-free exchange.
Section 1031 can be a powerful investment tool, and an incredibly useful estate planning tool. Taxpayers are encouraged to seek the advice of competent tax and legal counsel before structuring any 1031 exchange.

Mixed-Use 1031 Exchanges
A mixed-use exchange transaction occurs when a taxpayer sells property that includes their “primary personal residence,” and other land, structures, and other improvements used in a trade or business or held as an investment.
Some practical examples are:

A home office where a business pays the taxpayer rent for office space within the principal residence;
Farm and ranch land where the taxpayer works the land as their business, but lives in their principal residence also located on the property;
A duplex where the taxpayer lives in one unit as their principal residence and rents the other unit; and
A single family home with an accessory dwelling unit (“ADU”), attached or detached, and the taxpayer lives in the home as their principal residence and rents out the ADU.

The list is extensive, but mixed-use exchanges appear when there is a principal residence, commonly referred to as primary residence, on or within the land or building being conveyed as part of one transaction.
As a recap, Internal Revenue Code Section 1031(a)(1) provides: “In general no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” This section of the tax code is a tool to defer gains.
Another provision in the code, Section 121, provides that a taxpayer, “regardless of age, may exclude up to $250,000 ($500,000 for married persons filing jointly) of gain on the sale or exchange of his or her primary residence if, during the five-year period ending on the date of the sale or exchange, the property has been owned by the taxpayer as the taxpayer’s principal residence for periods aggregating two years or more.” Unlike IRC Section 1031, IRC Section 121 excludes capital gain taxes on the sale rather than deferring the tax with no strings attached to how the taxpayer reinvest their sale proceeds.
So, how does a taxpayer take advantage of both sections of the tax code at the same time? First, it’s important to identify your principal residence. A principal residence is not the taxpayer’s second home or vacation home which do not get the Section 121 benefit.
A principal residence is typically a taxpayer’s registered voting address, primary mailing address on your tax return, and other business documents, and the address on your driver’s licenses. As explained above, the principal residence may be part of a business use or investment property.
Here are some frequently asked questions about the interplay between Section 1031 and Section 121:
 
How is the exclusion amount calculated under IRC Section 121?
Simply consider the original purchase price of the residential portion of the property and the cost of any improvements made to the residence, which is the adjusted basis. Next determine the value of that portion of the property that comprises the residence which is generally a reasonable area that is enjoyed in conjunction with the home. If the taxpayer desires some proof of value, a current market analysis may be obtained from a Realtor® and there are other considerations discussed below. A formal appraisal is another way to substantiate the valuation.
To determine the exclusion amount, the taxpayer will find out if they file their taxes jointly or singly. Single filers can exclude the basis plus an additional $250,000. Joint filers can exclude the basis plus an additional $500,000. The resulting amount is simply cash in the taxpayer’s pocket.
Commonly, taxpayers find themselves with one purchase and sale contract containing both personal residence and 1031 real property with no specific allocation of value to the personal residence. Valuing the residential portion separately is arguably more art than science. The Current Market Analysis mentioned above is one approach. Some value considerations when making the analysis are: (1) the per acre value for a defined small parcel rural residential homesite being greater than per acre value for the much larger farm or ranch acreage; (2) homeowners insurance valuation for the primary residence possibly (3) the current taxable assessed value; and (4) the valuation of other amenities with the homesite that are part of the taxpayer’s enjoyment of the home. This is not an exhaustive list, and taxpayers are encouraged to consult their CPA or tax attorney for additional guidance.
How is the homesite defined in the context of the larger property being sold?
Aerial photos are a great resource in determining the reasonable configuration of the homesite. It’s reasonable to conclude that the principal residence is comprised of not only the house, but well, septic and drain field, landscaping, shelterbelts, ponds, small pastures associated with pets and horses, and any other features that lend to the enjoyment of the residence. Those features can become quite evident from aerial photos.
The resulting analysis of value is a valuable document to be included in the taxpayer’s file as part of the transaction. The taxpayer and their advisors can rely on this resource to not only arrive at the exclusion amount but can reference it from the file if the excluded amount is ever be questioned by the IRS.
Consider this simple hypothetical:

Total sale price $2,500,000
Principal residence valuation $800,000
Joint filing taxpayer’ basis in principal residence $300,000
Tax free cash to taxpayers $800,000.00
Section 1031 portion of the transaction $1,700,000

How can the 121 exclusion be used in the context of a property sale with debt payoff?
The 121 exclusion can provide benefits in addition to putting tax free cash in the taxpayer’s pocket. Assume the property sale in the example above required debt payoff to a lender of $500,000. Normally the taxpayer would then be required to exchange equal or up in value replacing $500,000 debt payoff with new debt or inserting new cash into the acquisition of the replacement property.
However, in our example, the taxpayer can allocate the debt payoff to the principal residence. That means the taxpayer doesn’t have to take on new debt or insert new cash into the replacement property acquisition and can retain the remaining $300,000 cash.
How is the 121 exclusion documented at closing?
Documenting the allocation of the sale proceeds partly to the personal residence exclusion and the 1031 exchange is relatively simple. The settlement statement for the relinquished property sale will contain a line item for “cash to exchanger (personal residence)” and a line item for “exchange proceeds to seller” which is the qualified intermediary.
Are there other situations where the 121 exclusion does not apply?
There are situations where the 121 exclusion cannot be used such as sales involving farms, ranches and other business properties which include the owners’ residences, but the entire property is owned by a corporation or partnership. Generally, the IRC Section 121 exclusion is available only to individuals, not S Corporations, C Corporations, or tax partnerships because these entities cannot own a principal residence. That said, business or other entities disregarded for tax purposes (i.e. single- member limited liability companies, sole proprietorships, and grantor trusts) can use the Section 121 exclusion.
In the situations referenced above, it may be possible to distribute the personal residence on the ranch, farm, or other business property out of the entity prior to the sale and exchange. However, it is best to employ some advance planning to assure the distribution takes place at least two years before the sale.
To summarize, the Section 121 exclusion provides taxpayers with tax free cash and no reinvestment requirement. For the personal residence portion of a sale of business use property Taxpayers may also allocate the excluded amount to any debt payoff at sale and eliminate the debt replacement requirements for the 1031 portion of the transaction. There are also opportunities for taxpayers to acquire property in a 1031 exchange, hold the property for five years, live in a residence on the property for two of those five years and claim the Section 121 exclusion on the sale of the residential portion in a subsequent sale transaction.
Note, however, that when participating in a 1031 exchange, the taxpayer’s intent with regard to the replacement property should be that it will be “held for productive use in a trade or business, or for investment” indefinitely. Taxpayers are encouraged to seek the guidance of tax and legal counsel when structuring 1031 exchanges, or when considering changing the character of the investment property.

Mixed-Use 1031 Exchanges
A mixed-use exchange transaction occurs when a taxpayer sells property that includes their “primary personal residence,” and other land, structures, and other improvements used in a trade or business or held as an investment.
Some practical examples are:

A home office where a business pays the taxpayer rent for office space within the principal residence;
Farm and ranch land where the taxpayer works the land as their business, but lives in their principal residence also located on the property;
A duplex where the taxpayer lives in one unit as their principal residence and rents the other unit; and
A single family home with an accessory dwelling unit (“ADU”), attached or detached, and the taxpayer lives in the home as their principal residence and rents out the ADU.

The list is extensive, but mixed-use exchanges appear when there is a principal residence, commonly referred to as primary residence, on or within the land or building being conveyed as part of one transaction.
As a recap, Internal Revenue Code Section 1031(a)(1) provides: “In general no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” This section of the tax code is a tool to defer gains.
Another provision in the code, Section 121, provides that a taxpayer, “regardless of age, may exclude up to $250,000 ($500,000 for married persons filing jointly) of gain on the sale or exchange of his or her primary residence if, during the five-year period ending on the date of the sale or exchange, the property has been owned by the taxpayer as the taxpayer’s principal residence for periods aggregating two years or more.” Unlike IRC Section 1031, IRC Section 121 excludes capital gain taxes on the sale rather than deferring the tax with no strings attached to how the taxpayer reinvest their sale proceeds.
So, how does a taxpayer take advantage of both sections of the tax code at the same time? First, it’s important to identify your principal residence. A principal residence is not the taxpayer’s second home or vacation home which do not get the Section 121 benefit.
A principal residence is typically a taxpayer’s registered voting address, primary mailing address on your tax return, and other business documents, and the address on your driver’s licenses. As explained above, the principal residence may be part of a business use or investment property.
Here are some frequently asked questions about the interplay between Section 1031 and Section 121:
 
How is the exclusion amount calculated under IRC Section 121?
Simply consider the original purchase price of the residential portion of the property and the cost of any improvements made to the residence, which is the adjusted basis. Next determine the value of that portion of the property that comprises the residence which is generally a reasonable area that is enjoyed in conjunction with the home. If the taxpayer desires some proof of value, a current market analysis may be obtained from a Realtor® and there are other considerations discussed below. A formal appraisal is another way to substantiate the valuation.
To determine the exclusion amount, the taxpayer will find out if they file their taxes jointly or singly. Single filers can exclude the basis plus an additional $250,000. Joint filers can exclude the basis plus an additional $500,000. The resulting amount is simply cash in the taxpayer’s pocket.
Commonly, taxpayers find themselves with one purchase and sale contract containing both personal residence and 1031 real property with no specific allocation of value to the personal residence. Valuing the residential portion separately is arguably more art than science. The Current Market Analysis mentioned above is one approach. Some value considerations when making the analysis are: (1) the per acre value for a defined small parcel rural residential homesite being greater than per acre value for the much larger farm or ranch acreage; (2) homeowners insurance valuation for the primary residence possibly (3) the current taxable assessed value; and (4) the valuation of other amenities with the homesite that are part of the taxpayer’s enjoyment of the home. This is not an exhaustive list, and taxpayers are encouraged to consult their CPA or tax attorney for additional guidance.
How is the homesite defined in the context of the larger property being sold?
Aerial photos are a great resource in determining the reasonable configuration of the homesite. It’s reasonable to conclude that the principal residence is comprised of not only the house, but well, septic and drain field, landscaping, shelterbelts, ponds, small pastures associated with pets and horses, and any other features that lend to the enjoyment of the residence. Those features can become quite evident from aerial photos.
The resulting analysis of value is a valuable document to be included in the taxpayer’s file as part of the transaction. The taxpayer and their advisors can rely on this resource to not only arrive at the exclusion amount but can reference it from the file if the excluded amount is ever be questioned by the IRS.
Consider this simple hypothetical:

Total sale price $2,500,000
Principal residence valuation $800,000
Joint filing taxpayer’ basis in principal residence $300,000
Tax free cash to taxpayers $800,000.00
Section 1031 portion of the transaction $1,700,000

How can the 121 exclusion be used in the context of a property sale with debt payoff?
The 121 exclusion can provide benefits in addition to putting tax free cash in the taxpayer’s pocket. Assume the property sale in the example above required debt payoff to a lender of $500,000. Normally the taxpayer would then be required to exchange equal or up in value replacing $500,000 debt payoff with new debt or inserting new cash into the acquisition of the replacement property.
However, in our example, the taxpayer can allocate the debt payoff to the principal residence. That means the taxpayer doesn’t have to take on new debt or insert new cash into the replacement property acquisition and can retain the remaining $300,000 cash.
How is the 121 exclusion documented at closing?
Documenting the allocation of the sale proceeds partly to the personal residence exclusion and the 1031 exchange is relatively simple. The settlement statement for the relinquished property sale will contain a line item for “cash to exchanger (personal residence)” and a line item for “exchange proceeds to seller” which is the qualified intermediary.
Are there other situations where the 121 exclusion does not apply?
There are situations where the 121 exclusion cannot be used such as sales involving farms, ranches and other business properties which include the owners’ residences, but the entire property is owned by a corporation or partnership. Generally, the IRC Section 121 exclusion is available only to individuals, not S Corporations, C Corporations, or tax partnerships because these entities cannot own a principal residence. That said, business or other entities disregarded for tax purposes (i.e. single- member limited liability companies, sole proprietorships, and grantor trusts) can use the Section 121 exclusion.
In the situations referenced above, it may be possible to distribute the personal residence on the ranch, farm, or other business property out of the entity prior to the sale and exchange. However, it is best to employ some advance planning to assure the distribution takes place at least two years before the sale.
To summarize, the Section 121 exclusion provides taxpayers with tax free cash and no reinvestment requirement. For the personal residence portion of a sale of business use property Taxpayers may also allocate the excluded amount to any debt payoff at sale and eliminate the debt replacement requirements for the 1031 portion of the transaction. There are also opportunities for taxpayers to acquire property in a 1031 exchange, hold the property for five years, live in a residence on the property for two of those five years and claim the Section 121 exclusion on the sale of the residential portion in a subsequent sale transaction.
Note, however, that when participating in a 1031 exchange, the taxpayer’s intent with regard to the replacement property should be that it will be “held for productive use in a trade or business, or for investment” indefinitely. Taxpayers are encouraged to seek the guidance of tax and legal counsel when structuring 1031 exchanges, or when considering changing the character of the investment property.

Mixed-Use 1031 Exchanges
A mixed-use exchange transaction occurs when a taxpayer sells property that includes their “primary personal residence,” and other land, structures, and other improvements used in a trade or business or held as an investment.
Some practical examples are:

A home office where a business pays the taxpayer rent for office space within the principal residence;
Farm and ranch land where the taxpayer works the land as their business, but lives in their principal residence also located on the property;
A duplex where the taxpayer lives in one unit as their principal residence and rents the other unit; and
A single family home with an accessory dwelling unit (“ADU”), attached or detached, and the taxpayer lives in the home as their principal residence and rents out the ADU.

The list is extensive, but mixed-use exchanges appear when there is a principal residence, commonly referred to as primary residence, on or within the land or building being conveyed as part of one transaction.
As a recap, Internal Revenue Code Section 1031(a)(1) provides: “In general no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” This section of the tax code is a tool to defer gains.
Another provision in the code, Section 121, provides that a taxpayer, “regardless of age, may exclude up to $250,000 ($500,000 for married persons filing jointly) of gain on the sale or exchange of his or her primary residence if, during the five-year period ending on the date of the sale or exchange, the property has been owned by the taxpayer as the taxpayer’s principal residence for periods aggregating two years or more.” Unlike IRC Section 1031, IRC Section 121 excludes capital gain taxes on the sale rather than deferring the tax with no strings attached to how the taxpayer reinvest their sale proceeds.
So, how does a taxpayer take advantage of both sections of the tax code at the same time? First, it’s important to identify your principal residence. A principal residence is not the taxpayer’s second home or vacation home which do not get the Section 121 benefit.
A principal residence is typically a taxpayer’s registered voting address, primary mailing address on your tax return, and other business documents, and the address on your driver’s licenses. As explained above, the principal residence may be part of a business use or investment property.
Here are some frequently asked questions about the interplay between Section 1031 and Section 121:
 
How is the exclusion amount calculated under IRC Section 121?
Simply consider the original purchase price of the residential portion of the property and the cost of any improvements made to the residence, which is the adjusted basis. Next determine the value of that portion of the property that comprises the residence which is generally a reasonable area that is enjoyed in conjunction with the home. If the taxpayer desires some proof of value, a current market analysis may be obtained from a Realtor® and there are other considerations discussed below. A formal appraisal is another way to substantiate the valuation.
To determine the exclusion amount, the taxpayer will find out if they file their taxes jointly or singly. Single filers can exclude the basis plus an additional $250,000. Joint filers can exclude the basis plus an additional $500,000. The resulting amount is simply cash in the taxpayer’s pocket.
Commonly, taxpayers find themselves with one purchase and sale contract containing both personal residence and 1031 real property with no specific allocation of value to the personal residence. Valuing the residential portion separately is arguably more art than science. The Current Market Analysis mentioned above is one approach. Some value considerations when making the analysis are: (1) the per acre value for a defined small parcel rural residential homesite being greater than per acre value for the much larger farm or ranch acreage; (2) homeowners insurance valuation for the primary residence possibly (3) the current taxable assessed value; and (4) the valuation of other amenities with the homesite that are part of the taxpayer’s enjoyment of the home. This is not an exhaustive list, and taxpayers are encouraged to consult their CPA or tax attorney for additional guidance.
How is the homesite defined in the context of the larger property being sold?
Aerial photos are a great resource in determining the reasonable configuration of the homesite. It’s reasonable to conclude that the principal residence is comprised of not only the house, but well, septic and drain field, landscaping, shelterbelts, ponds, small pastures associated with pets and horses, and any other features that lend to the enjoyment of the residence. Those features can become quite evident from aerial photos.
The resulting analysis of value is a valuable document to be included in the taxpayer’s file as part of the transaction. The taxpayer and their advisors can rely on this resource to not only arrive at the exclusion amount but can reference it from the file if the excluded amount is ever be questioned by the IRS.
Consider this simple hypothetical:

Total sale price $2,500,000
Principal residence valuation $800,000
Joint filing taxpayer’ basis in principal residence $300,000
Tax free cash to taxpayers $800,000.00
Section 1031 portion of the transaction $1,700,000

How can the 121 exclusion be used in the context of a property sale with debt payoff?
The 121 exclusion can provide benefits in addition to putting tax free cash in the taxpayer’s pocket. Assume the property sale in the example above required debt payoff to a lender of $500,000. Normally the taxpayer would then be required to exchange equal or up in value replacing $500,000 debt payoff with new debt or inserting new cash into the acquisition of the replacement property.
However, in our example, the taxpayer can allocate the debt payoff to the principal residence. That means the taxpayer doesn’t have to take on new debt or insert new cash into the replacement property acquisition and can retain the remaining $300,000 cash.
How is the 121 exclusion documented at closing?
Documenting the allocation of the sale proceeds partly to the personal residence exclusion and the 1031 exchange is relatively simple. The settlement statement for the relinquished property sale will contain a line item for “cash to exchanger (personal residence)” and a line item for “exchange proceeds to seller” which is the qualified intermediary.
Are there other situations where the 121 exclusion does not apply?
There are situations where the 121 exclusion cannot be used such as sales involving farms, ranches and other business properties which include the owners’ residences, but the entire property is owned by a corporation or partnership. Generally, the IRC Section 121 exclusion is available only to individuals, not S Corporations, C Corporations, or tax partnerships because these entities cannot own a principal residence. That said, business or other entities disregarded for tax purposes (i.e. single- member limited liability companies, sole proprietorships, and grantor trusts) can use the Section 121 exclusion.
In the situations referenced above, it may be possible to distribute the personal residence on the ranch, farm, or other business property out of the entity prior to the sale and exchange. However, it is best to employ some advance planning to assure the distribution takes place at least two years before the sale.
To summarize, the Section 121 exclusion provides taxpayers with tax free cash and no reinvestment requirement. For the personal residence portion of a sale of business use property Taxpayers may also allocate the excluded amount to any debt payoff at sale and eliminate the debt replacement requirements for the 1031 portion of the transaction. There are also opportunities for taxpayers to acquire property in a 1031 exchange, hold the property for five years, live in a residence on the property for two of those five years and claim the Section 121 exclusion on the sale of the residential portion in a subsequent sale transaction.
Note, however, that when participating in a 1031 exchange, the taxpayer’s intent with regard to the replacement property should be that it will be “held for productive use in a trade or business, or for investment” indefinitely. Taxpayers are encouraged to seek the guidance of tax and legal counsel when structuring 1031 exchanges, or when considering changing the character of the investment property.