Revenue Procedure 2005-14: Section 121 Then Section 1031

Revenue Procedure 2005-14 is the IRS guidance that lets you use the Section 121 home-sale exclusion and a Section 1031 like-kind exchange on the same property. The rule is one of order: apply Section 121 to the realized gain first, then defer whatever gain remains under Section 1031. Published in Internal Revenue Bulletin 2005-7 on February 14, 2005, it remains current guidance and is still referenced in Publication 523 and the 2025 Instructions for Form 8824.¹²

The classic situation this procedure was written for is a home you lived in, then converted to a rental, and now want to exchange for other investment real estate. Section 121 excludes up to $250,000 of gain ($500,000 for joint filers) if you owned and used the home as your principal residence for at least two of the five years before the sale.³ Section 1031 defers gain on real property held for business or investment when it is exchanged for like-kind real property.⁴ Revenue Procedure 2005-14 tells you how the two fit together in a single transaction.

Section 121 First, Then Section 1031

The exclusion runs before the deferral. You shelter as much of the realized gain as the $250,000 or $500,000 cap allows, and only the leftover gain moves into the like-kind exchange calculation.⁵ If the exclusion covers everything, no gain is deferred because none remains. If it doesn’t, the balance is deferred under Section 1031 if the exchange otherwise qualifies.

Depreciation Gain Cannot Be Excluded, But It Can Be Deferred

Section 121(d)(6) blocks the exclusion from covering gain attributable to depreciation deductions taken after May 6, 1997.⁵ That portion of the gain still qualifies for Section 1031 deferral, though, which matters because depreciation recapture is otherwise taxed at up to 25%.⁶ Combining the two provisions lets you exclude the ordinary appreciation and defer the depreciation piece rather than pay tax on it now.

How Boot Is Treated

Cash or other non-like-kind property you receive in an exchange is boot, and in a straight Section 1031 it triggers recognized gain. Under Revenue Procedure 2005-14, boot counts for Section 1031(b) purposes only to the extent it exceeds the gain already excluded under Section 121.⁵ The exclusion absorbs the boot first. If the excluded gain is large enough, you recognize nothing on the cash you received.

Basis of the Replacement Property

Under Section 1031(d), the replacement property’s basis starts with the adjusted basis of the relinquished business property. You then increase that figure by any Section 121 gain excluded that is attributable to the relinquished business property, and decrease it by the boot received.⁵ The upward adjustment for excluded gain is what prevents that same gain from being taxed a second time when you eventually sell the replacement property.

Mixed-Use Properties

If a single property serves partly as your home and partly as a business or rental, Section 2.03 of the procedure requires you to allocate basis and amount realized between the two portions using the same method you used for depreciation, such as square footage.⁵

Whether the business use sits inside the same dwelling unit or in a separate structure changes the answer. A home office inside the house is part of the dwelling unit, and the whole property is treated as the principal residence for the two-year use test. A detached structure used for business, like a separate guesthouse-turned-office, is treated on its own: Section 121 reaches the gain on that structure only if you independently met the two-year use requirement for it.⁵

A Worked Example

The procedure’s first example ties the mechanics together. A taxpayer buys a house for $210,000, lives in it from 2000 to 2004, then rents it out through 2006 and claims $20,000 in depreciation. She exchanges it for $10,000 cash plus a $460,000 rental townhouse, realizing $280,000 in gain.⁷

Section 121 excludes $250,000 of that gain. The remaining $30,000, which includes the $20,000 of depreciation gain that Section 121 cannot touch, is deferred under Section 1031. The $10,000 cash is not recognized because it does not exceed the excluded gain. The basis of the replacement townhouse works out to $430,000: the $190,000 adjusted basis of the relinquished property, plus the $250,000 excluded gain, minus the $10,000 cash received.⁷

Two Later Rules That Limit the Strategy

Two statutes enacted after Revenue Procedure 2005-14 changed what taxpayers can do around it.

Five-Year Hold After a 1031 Acquisition

Section 121(d)(10), added by the American Jobs Creation Act of 2004, blocks the Section 121 exclusion on any property you acquired through a Section 1031 exchange if you sell it within five years of the acquisition date.⁸ It applies to exchanges completed on or after October 22, 2004. The rule closes off the move of taking replacement property in a deferred exchange, moving in, and quickly selling with the exclusion.

Nonqualified Use Proration

The Housing and Economic Recovery Act of 2008 added Section 121(b)(5), which prorates the exclusion based on periods of “nonqualified use” occurring on or after January 1, 2009. Nonqualified use is any period the property was not your principal residence, and the reduction equals total gain multiplied by the ratio of nonqualified-use periods to total ownership.⁹¹⁰

The statute excludes from that count any nonqualified use that occurs after the last date the property was used as your principal residence. If you lived in the home first and then converted it to a rental before the exchange, the rental period does not shrink your exclusion, so long as you still meet the two-of-five-year ownership and use tests.¹⁰ That live-first, rent-later, exchange-last sequence is the pattern Revenue Procedure 2005-14 was written for, so the proration rule seldom bites on these transactions.

Getting a Vacation Home to Qualify in the First Place

Revenue Procedure 2005-14 assumes the property already qualifies as both a principal residence and business or investment property. It does not tell you whether a second home or vacation home that gets occasional rental use counts as “held for investment” under Section 1031. That question is answered by Revenue Procedure 2008-16.

The Tax Court had ruled in Moore v. Commissioner (T.C. Memo. 2007-134) that two lakeside vacation properties used only for personal enjoyment did not qualify for Section 1031, because a hope of future appreciation is not investment intent when the property is used as a residence.¹¹ Revenue Procedure 2008-16, effective for exchanges on or after March 10, 2008, gives a safe harbor for dwelling units that are rented but also used personally. The IRS will not challenge the property’s investment status if, during each of the two 12-month periods within the 24 months before the relinquished property is exchanged (or after the replacement property is received):

The unit is rented at fair rental for at least 14 days, and
Personal use does not exceed the greater of 14 days or 10% of the days the unit was rented at fair rental.

Meeting the safe harbor does not waive the other Section 1031 requirements. The 45-day identification deadline, the 180-day closing deadline, and the use of a qualified intermediary still apply.¹² In practice, Revenue Procedure 2008-16 establishes that a mixed-use dwelling is investment property, and Revenue Procedure 2005-14 then handles the mechanics of combining Sections 121 and 1031 on it.¹³

1
Internal Revenue Service. Instructions for Form 8824 (2025)
2
Internal Revenue Service. Publication 523, Selling Your Home
3
Internal Revenue Service. Topic No. 701, Sale of Your Home
4
Internal Revenue Service. Like-Kind Exchanges — Real Estate Tax Tips
5
U.S. Department of the Treasury. Revenue Procedure 2005-14
6
The Tax Adviser. Converting a Rental or Vacation Home Into a Primary Residence
7
API Exchange. Rev. Proc. 2005-14
8
Bloomberg Tax. IRC Section 121
9
Office of the Law Revision Counsel. 26 USC 121
10
The Tax Adviser. New Rules Seek to Reduce Tax Advantages of Converting Second Home to Principal Residence
11
The Tax Adviser. Sale of Vacation Home Disallowed as Tax-Free Like-Kind Exchange
12
Internal Revenue Service. Revenue Procedure 2008-16
13
The Tax Adviser. IRS Provides Sec. 1031 Personal Use Safe Harbor for Dwellings