121 First use reset

Technical topics regarding tax preparation.
#1
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Client owns principal residence and second home. Wants to sell second home sometime in near future. Could live in 2nd home for next 2 years as principal residence but is facing long non qualified use period. Is there some way he can reset first use of 2nd home, example edit: contribute to his newly elected S corp( or better yet current LLC if that works) and then distribute home to shareholder/LLC member after sometime reasonable time like a tax year?
 

#2
msawyer  
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"Is there some way he can reset first use of 2nd home"

No. There is nothing in IRC 121(b)(5)(C)(i) that requires the period(s) of ownership to be continuous.

§ 1.121-1(c)(3)(ii) also indicates that ownership by a disregard entity is treated as ownership by the individual.

And although not evidence, I feel strongly that if it what you propose was allowed, there would be five hundred journal articles out there by now about how to do the "back door Sec. 121" to circumvent the law (Housing Assistance Tax Act of 2008) that was enacted to close the exact unintended loophole you want to exploit.
 

#3
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Great question. Let me preface my comments with the language in 121(b)(5):

(5) Exclusion of gain allocated to nonqualified use.
(A) In general. Subsection (a) shall not apply to so much of the gain from the sale or exchange of property as is allocated to periods of nonqualified use.
(B) Gain allocated to periods of nonqualified use. For purposes of subparagraph (A) , gain shall be allocated to periods of nonqualified use based on the ratio which—
(i) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to
(ii) the period such property was owned by the taxpayer.


Ok. Under (i) and (ii) the phrase “owned by the taxpayer” is used. If we were to disrupt the ownership chain here, by contributing the property to a partnership, for example, and then later getting it back via distribution…what about all that “pre-partnership” individual ownership time – would that time count when the individual later sells the property and we run our Sec 121 calculations? Let’s call this Example 1.

That to me is a highly critical question that we need an answer to.

Let me also toss out this example. Let’s call this Example 2:

Individual owns a primary residence for a number of years. He lives in it, maybe rents it some before and/or after his own occupancy, etc. Whatever. He sells that property to an unrelated party in 2014. About eight years later, on 1/1/2022, he buys that exact same property back that he used to live in. He lives in that property (as his primary residence) for 2 full years and then sells it on 1/1/24. With respect to this 2024 sale, the question is: Does any of that 2014 and pre-2014 time period factor into our Sec 121 calculations?

And here’s Example 3:

I own a vacation house. Let’s say it was never my primary residence. In 2015, I gift it to my elderly parent. That parent passes away in 2021. I inherit it through parent’s will and begin using it as my primary residence. Basis gets reset. I sell it in 2024. Same question as above: Does any period associated with my pre-gift ownership factor into my 2024 Sec 121 calculations?

All 3 examples have something in common: There was a break in the ownership chain. Where the examples diverge is how our prior ownership “temporarily” ceased and how we ended up getting the property back. In Example 1, cessation was due to a partnership contribution. Reacquisition was via a partnership distribution. In Example 2, cessation was due to an outright sale. Reacquisition was due to an outright purchase. In Example 3, cessation was due to a gift. Reacquisition was via an inheritance.

I have to believe that whatever answer we come up with, with respect to the highly critical question posed above, needs to apply across the board. Our prior ownership, before the break in ownership, either does or doesn’t factor into our current year Sec 121 sale calculations.

With that said, if we find that breaking the ownership chain does indeed reset ownership and usage, then I might offer up the following:

Parents contribute the property to the partnership. Let’s say the property is worth $950k (and has no debt). We get a child, or some other friendly party, to contribute $50k. Now we have a 95/5 partnership. Partnership rents the property at a fair rental amount. Either back to parents, a family member, or an unrelated party. (Maybe an unrelated party is the best idea). Maybe we rent for a year. And then we distribute the property out to parents, who immediately convert it to a primary residence, live in it for 2-years and then sell it. The third partner would get a cash distribution, based on his/her share of the actual value of the partnership.

We’d need to think through our land/building allocation inside the partnership. Do we want a high structure basis or a low one? Although depreciation would be recaptured on the subsequent sale, no biggie if the parents actually got a benefit from it. We’d need to think through the numbers in terms of operating income and expenses and overall income tax consequences, including the passive rules. We need to think about who the tenant will be. If parents, they won’t get a deduction for the rent paid, but the partnership will have taxable rental income. If parents end up paying rent to themselves (more or less), will we be creating a taxable situation that will eat into the tax benefits of the 121 exclusion? But we’d bear in mind that the partnership can now cover the operating expenses, which were heretofore non-deductible to the parents. We’d need to know about legal costs, tax stamps, etc. that might arise on the partnership contribution and distribution. Would those costs significantly eat into the Sec 121 benefits? And finally, we’d need to consider the anti-abuse rules of Subchapter K. But this is why structuring this thing a certain way would be advisable (i.e. adding a third partner – who makes a capital contribution, charging fair rent, actually switching title around on a formal basis, making cash distributions to all the partners, liquidating the partnership based on true values – with the third partner actually making a profit, ideally).

And note: You’d have a 704c situation.

Also note the one PLR about individuals contributing the property to a partnership and then IRS allowing the 121 exclusion. But that PLR was revoked. The grounds for that revocation (although not specifically stated, but we can easily guess) would likely weigh in favor of the idea presented above (although in the PLR, the partnership didn’t rent the property).
 

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Thanks Jeff-Ohio. I will check out the PLR.
I am also looking into using the "use" as a key driver in getting maximum 121 exclusion without any ownership change.
1. 121(b)(5)(C)(ii) says "The term “period of nonqualified use” does not include—
(I)any portion of the 5-year period described in subsection (a) which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer’s spouse"
So if client used 2nd home as a PR even after first use as a vacation home or rental, then the following 5 years are excluded from being non qualided use.
See https://www.cpajournal.com/2020/02/05/h ... omeowners/ and viewtopic.php?f=8&t=25884
2. The CPA Journal article points out its really a numbers game. "In certain situations, however, the way that the rules are written permits the maximum exclusion even in cases of nonqualified use. As long as the nonqualified use ratio allocates a sufficiently small amount, the maximum exclusion can still be taken."
 

#5
msawyer  
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TAXMASTER wrote:So if client used 2nd home as a PR even after first use as a vacation home or rental, then the following 5 years are excluded from being non qualided use

Wrong. Two of those five years must include the period of principal residence, so you have up to three years following the last date of use as PR to get any exclusion.

Still nothing in Sec. 121 or the regs. that says periods of ownership only count if they are continuous.
 

#6
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Wrong. Two of those five years must include the period of principal residence, so you have up to three years following the last date of use as PR to get any exclusion.


Ok, lets try an example(based on true story): Client couple buys model sale home from over 55 senior community builder halfway thru subdivision development. Client rents back to builder for 2 years at FMV until builder completes development( files Schedule E etc). Clients not sure they want to live in senior development for long term, so start out using new home as principal residence for 3 years. Clients then decides senior development not for then, but CA prices skyrocketing so decide to keep home as a second home for 5 years. Client then needs to cashout, so moves back in as PR for the minimum required 2 years to take advantage of 121 exclusion. Total 12 years of ownership with first use as a rental.
The non qualified use period is:
1. 2 years
2. 7 years
3. None of the above
 

#7
msawyer  
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Let's see, all ownership is post 2009? Yes, check. Period of use as other than principal residence, after the last date such property is used as the principal residence? Zero, check.

So, seven years of non-qualified use.

Note that there is only one last date that the property is used as a principal residence. The only "five year period" is the one ending on the date of sale or exchange, there are no five-year periods prior to that that mean anything special (except for one related to like kind exchanges).
 

#8
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7 years is correct. See viewtopic link in post 4 for related case.
 

#9
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2. The CPA Journal article points out its really a numbers game. "In certain situations, however, the way that the rules are written permits the maximum exclusion even in cases of nonqualified use. As long as the nonqualified use ratio allocates a sufficiently small amount, the maximum exclusion can still be taken."

This is true. However, you did say this:

but is facing long non qualified use period.


So the strategy described in the article might not be entirely workable. You didn’t give us any details. But if we follow the article’s example (regarding the $700k gain and the 5/8th’s and 3/8th’s)…and assume 14-years of non-qualfied use (2010 to 2024), then our “qualified use” fraction would be 3/17…times $700k = $123,529. Not such a great result. Note the article example dealt with a single taxpayer. In your case, a joint return might be involved. You didn’t say.

As to your #1, I think we’d be looking at a similar thing. But I get it. You’d just be angling for more favorable fractions.

Also note that, no matter what, we still have to deal with/consider the initial primary residence (IPR). If he moves out of the IPR and into the Second Home, then the IPR is not his primary residence during that second home occupancy/residency period of time. Whatever issues come of this would depend on the facts. That is, will the IPR be rented after he moves out? Will he later move back into the IPR? Is his intention to hold the IPR until death?

Still nothing in Sec. 121 or the regs. that says periods of ownership only count if they are continuous.

Agreed, at least as to the Code. I don’t think the Regs address non-qualified use at all, but check me on it. The question, though, is whether or not the code actually contemplated some of the examples I presented. The 2 examples in the General Explanation of the Act don’t come close to addressing the situation.

One problem with your argument is that you might end up with duplicative periods of NQ use. That is, the same period of non-qualfied use that counts against you in more than one sales transaction.

For example, let’s say that a while ago, you owned House1 and had periods of NQ use. You sell House1 and pay tax on the gain associated with periods of NQ use. Years later, you rebuy House1. You use it as your primary residence for 2+ years and then sell it for a $250k gain. Are you telling us that the NQ period associated with your prior ownership of House1 counts against you again with respect to the second sale of House1, such that we actually end up paying some tax on the second sale? Is that your position?
 

#10
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Still nothing in Sec. 121 or the regs. that says periods of ownership only count if they are continuous.
Agreed, at least as to the Code. I don’t think the Regs address non-qualified use at all, but check me on it. The question, though, is whether or not the code actually contemplated some of the examples I presented. The 2 examples in the General Explanation of the Act don’t come close to addressing the situation. One problem with your argument is that you might end up with duplicative periods of NQ use. That is, the same period of non-qualfied use that counts against you in more than one sales transaction.For example, let’s say that a while ago, you owned House1 and had periods of NQ use. You sell House1 and pay tax on the gain associated with periods of NQ use. Years later, you rebuy House1. You use it as your primary residence for 2+ years and then sell it for a $250k gain. Are you telling us that the NQ period associated with your prior ownership of House1 counts against you again with respect to the second sale of House1, such that we actually end up paying some tax on the second sale? Is that your position?


That was msawyer's quote not mine. I agree if you rebuy House 1 prior NQ use has no bearing. Looks like unless the ownership is reset you are stuck with ratio of PR use over period of ownership and the best you can do is to maximize PR use. So back to my original post.
 

#11
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That was msawyer's quote not mine.


No one said it was your quote.

I agree if you rebuy House 1 prior NQ use has no bearing.

Msawyer would perhaps disagree.

So back to my original post.


Ok. But an idea has already been posted about a partnership contribution possibly working to reset.
 


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