DISCLAIMER: I am not a tax accountant or tax law expert, so you should consult with each accordingly for deeper questions. Also, this is educational material and does not constitute legal advice nor is any attorney/client relationship created with this article, hence you should contact and engage an attorney if you have any legal questions.

If you’re a real estate beginner — perhaps you’re about to buy your first house; or, more likely if you’re reading this article, you’re thinking of selling your first home — chances are you’ve heard about the 1031 Exchange. And no matter how many articles you read about the 1031 Exchange, no matter how many YouTube videos you watch, it seems like you end up with more questions than were answered; and you probably walk away with some vague takeaway that “if you live in a home for two years, and if you sell it, and then immediately buy another home, then you can avoid being taxed on the gains from the sale.”

And you’d be very, very wrong.

Because as it turns out, the 1031 Exchange has nothing to do with selling “your home” — that’s what the Section 121 Exclusion is for — and everything to do with selling (and buying) “investment properties.”

So let’s clarify things about the 1031 Exchange by introducing another section of the Tax Code, the Section 121 Exclusion, and understanding how they’re different. We’ll discuss the 1031 Exchange first, and contrast it against the 121 Exclusion afterwards.

1031 Exchange vs. Section 121 Exclusion

In general, the 1031 Exchange is used if you’re selling an investment property and planning to purchase another investment property; this is the so-called “like-for-like” exchange that is contemplated by the “exchange” portion of Section 1031. More on this later.

The Section 121 Exclusion, on the other hand, is concerned simply with whether you are selling your primary residence and buying another primary residence. So in a sense this is “like-for-like,” too, but the key distinction lies in the purpose or nature of the dwelling: this is used for primary residences or “forever homes,” while the 1031 Exchange is used for investment properties.

So let’s dive into the two of these in detail.

What is the 1031 Exchange and how does it work?

Simply put, the 1031 Exchange (here) allows for the deferral of capital gains taxes on the sale of an investment property, provided another investment property is purchased within a specific time frame. So essentially, it’s a tax incentive to keep investing in rental property: as long as you keep investing, you can keep deferring taxable gains.

So let’s break this down. First, let’s remember the general rule about taxes, which can be roughly summarized as “all income is taxable income unless some exception applies.” So the idea is that if you bought an investment property, like a rental home, for $1M and sold it for $1.5M, you would have realized $500K in gains, hence you would have to pay taxes on those $500K.

But the 1031 Exchange allows you to “defer” these taxes to a future date (discussed below) if you can quickly identify and purchase another investment property. An investment property for these purposes is by definition a home that you are using, for instance, as a rental property, i.e., you are a landlord renting out the home to tenants; it is not your primary residence (usually defined as the place where your vehicles are registered and where you receive your bills and other postal mail).

(If you own rental property, make sure you understand things like the Implied Warranty of Habitability, California’s new rental laws for 2024, and more.)

The critical (and difficult) thing here is to quickly identify and purchase another investment property: you have 45 days to identify the target property and 180 days to close on the purchase of that property. There are details beyond the scope of this brief discussion, but this is the high level information you need to understand.

If you have identified and purchased a new property within those timeframes, then the taxes on the gains of the investment property you would have otherwise owed would indeed be deferred until a later time; this means, using the numbers above, that the taxes owed on the $500K of gains would not need to be paid.

(Note that if the new investment property is worth less than the prior sold property, this difference (known as the “boot”) will be taxable.)

The concept of deferring capital gains taxes is what it sounds like: it’s not a forgiveness of the taxes owed, it’s literally a deferral, where the end date is whenever you stop doing 1031 Exchanges; and unless and until you stop, you can continue to “piggyback” or “daisy chain” those deferrals as long as you like. But as soon as you break the chain — as soon as you sell an investment property without identifying and purchasing a new one within the 45 and 180 day limits — then your taxes owed on the various investment properties’ sales gains will become due.

So that’s the idea behind a 1031 Exchange: to defer taxable gains as long as you continuously sell and purchase like-for-like investment properties.

What is the Section 121 Exclusion and how does it work?

The Section 121 Exclusion — which is probably what people often think about when trying to understand the 1031 Exchange, even if they’ve never heard of the 121 Exclusion before — is sort of the corollary, or inverse, in a sense, to a 1031 Exchange.

Where the 1031 Exchange is strictly about deferring taxable gains if you continue to invest in like-for-like investment properties, the 121 Exclusion is a tax incentive for people to buy a primary residence or “forever home.”

The 121 Exchange (here) says that if you’ve lived in a primary residence for a certain amount of time, then once you sell it and then buy a new primary residence, you can exclude a certain amount of taxable gains.

Using our same numbers as above, let’s suppose you sold your primary residence, originally purchased for $1M, for $1.5M; you gained $500K during your ownership of the home. Now you decide to sell the home and your plan is to use the money from the sale to purchase a new “forever home,” i.e., a new primary residence.

If you’ve lived in the home for at least 24 months (2 years) out of the prior 60 months (5 years), you can then exclude — not merely “defer” — your gains of up to $250,000 (single) or $500,000 (married). The 24 month requirement is not consecutive: this means you can move out and then move back in again; what matters is that you accumulate at least 24 months in the past 60 months.

Interestingly, there is no requirement to actually purchase another home after selling; the policy behind this law aims to incentivize the purchase of “forever homes.” By allowing homeowners to exclude some or potentially all of the taxable gains from the sale of a primary residence, the law makes it financially easier for people to transition into new homes. Furthermore, this tax exclusion encourages the initial purchase of a primary residence by mitigating the potential tax burden upon sale. Without such incentives, the financial challenges could deter individuals from both selling and buying primary residences, effectively discouraging home ownership.

Final thoughts

The 1031 Exchange and Section 121 Exclusion are both extremely powerful tools; but it’s easy to get the two confused, both in terms of application as well as requirements. The practical takeaway is pretty straightforward, however:

If you own rental (investment) property, and if you plan to sell it, definitely make sure to identify (within 45 days) and purchase (within 180 days) a new rental property so that you can defer any gains on the sale of the first property.

If you’re planning on selling your primary home and looking for your next primary residence or “forever home,” make sure you’ve lived in it for at least 24 consecutive months in the past 60 months before selling. This way, you can fully exclude up to $500K in taxable gains if married (or $250K if not married) when you sell it, allowing you to pocket more money from the sale that you can then put towards your new “forever home.”

Hopefully this helps clarify the admittedly confusing options available to home owners looking to sell either investment or primary residence properties.