Finance & Jobs, Lifestyle

1031 Exchange vs. Home-Sale Exclusion (Sec. 121): A Practical Guide for Retirees Moving States

If you want to sell a high-value property and roll the proceeds into multiple new homes (one to live in, one or more as rentals), there are two different tax regimes at play:

  • Section 121 (home-sale exclusion) for your principal residence (up to $500,000 of gain excluded if married filing jointly). Principal residences do not qualify for 1031. IRS+1
  • Section 1031 (like-kind exchange) for investment/business real estate only (strict deadlines and rules; lets you defer capital gain and depreciation recapture). Since 2018, 1031 applies to real property only. IRS+1

Below is a clear roadmap—including “must-do” steps—and a numeric walkthrough for a couple selling in California and relocating to Georgia.

First, what a 1031 exchange is (and isn’t)

  • Purpose: Defer capital gains by swapping investment real estate for other like-kind investment real estate. Funds must be parked with a Qualified Intermediary (QI); you can’t touch the cash. Legal Information InstituteIRS
  • Clock: Identify replacement properties within 45 days, close within 180 days (these periods run concurrently). IRS
  • Identify multiples: Use the 3-property rule (any 3, any value) or the 200% rule (any number as long as total value ≤ 200% of what you sold). There’s also a 95% rule backstop. Legal Information Institute
  • Value & debt: To fully defer tax, acquire equal or greater value and reinvest all net equity. If your overall liability goes down and you don’t add cash to offset it, the reduction is taxable “boot.” The Tax AdviserIPX1031
  • Personal use prohibited: You cannot exchange into a personal home. Replacement(s) must be held for investment or business use. IRS

Tip: If you plan to convert a rental to a primary later, special rules apply: property received in a 1031 must be held at least 5 years before you can claim a later Sec. 121 exclusion, and post-2008 “nonqualified use” periods reduce the exclusion. FirstExchangeLegal Information Institute

MUST-DO Steps (checklist)

A) When selling investment property and doing a 1031

  1. Retain a QI before closing your sale. If you or your agent receive the funds, the exchange fails. (QI safe harbor in Treas. Reg. 1.1031(k)-1(g)(4).) IRS
  2. Sign the exchange addenda with your escrow/closing and QI; have proceeds wired to the QI. eCFR
  3. Identify up to 3 properties (or use 200% rule) by Day 45, close by Day 180. Legal Information Institute
  4. Reinvest all equity and replace debt (or add cash equal to any debt reduction) to avoid boot. The Tax Adviser
  5. Report on Form 8824 with your tax return. If you exchanged California property into out-of-state property, file FTB Form 3840 annually so California can track deferred CA-source gain (“claw-back”). Lifetime Paradigm
  6. Do not occupy the replacement for personal use (if you later convert, respect the 5-year rule and nonqualified-use proration). FirstExchangeLegal Information Institute

B) When selling your principal residence

  1. Confirm you meet the 2-of-5 year ownership & use tests for the $500,000 exclusion (MFJ). Use IRS Pub. 523 worksheets. IRS
  2. Remember: Mortgage payoff does not affect your taxable gain; your gain is sale price – selling costs – adjusted basis (basis = purchase + improvements – certain adjustments). IRS
  3. California will tax any taxable portion of a gain from CA real property whether you sell as a resident or a nonresident (it’s CA-source income). Franchise Tax Board
  4. After closing, you generally do not report the sale if your entire gain is excluded; otherwise, report the taxable portion. (See Pub. 523 & Topic 701.) IRS+1


Your scenario: Loan & Minh (married), sell California home in 2025 for $1.5M, mortgage $300k, then move to Georgia

Key Point Upfront:

A principal residence cannot be exchanged under 1031. The usual path is to take the Sec. 121 exclusion and pay tax (if any) on the remainder, then buy your Georgia primary home and a separate rental. If you wanted 1031 treatment, you’d need to first convert the CA home to a true rental (see safe-harbor below), then exchange into Georgia rentals—but you still cannot use exchange funds to buy your Georgia primary home. IRS+1

Step 1 — Compute the gain on the home sale

Assume (for illustration) you bought years ago for $500,000 and made $100,000 of capital improvements. Also assume typical 6% selling costs ($90,000).

  • Amount realized: $1,500,000 – $90,000 = $1,410,000
  • Adjusted basis: $500,000 + $100,000 = $600,000
  • Total gain: $1,410,000 – $600,000 = $810,000

Mortgage payoff ($300,000) is not part of the gain calculation—it just affects your cash at closing. IRS

Sec. 121 exclusion (MFJ): $500,000 → taxable gain = $810,000 – $500,000 = $310,000 (illustrative—your facts may differ). IRS

Very rough tax sense-check (illustrative only):
If you’re in the top federal LTCG bracket and subject to the 3.8% NIIT, and in a mid-range CA bracket, ballpark tax on $310,000 might look like:

  • Federal LTCG 20% ≈ $62,000
  • NIIT 3.8% ≈ $11,780 (threshold for MFJ is $250,000 MAGI). API Exchange
  • CA income tax (capital gains taxed as ordinary income) ~9.3% example ≈ $28,830 (rate depends on your taxable income). Franchise Tax Board

Total ≈ $102,610 (illustrative). Use Pub. 523 worksheets and your actual basis, brackets, and closing costs to refine. IRS

Step 2 — Reinvest after the sale

  • Georgia primary home: Buy with post-tax proceeds (Sec. 121 doesn’t limit what you buy next).
  • Georgia rental home(s): Also buy with post-tax proceeds or—if you own other investment property—consider a 1031 on those (not your principal residence) to acquire multiple GA rentals.

Why not 1031 your home? Because 1031 requires investment/business use; the principal residence rules (Sec. 121) already give you a powerful exclusion. IRS

Optional “pre-plan” to defer more than $500k of gain

If you haven’t sold yet and can wait:

  1. Convert the CA home to a rental (true investment intent). A safe harbor many tax pros use is Rev. Proc. 2008-16: own it for 24 months and, in each 12-month period, rent it out ≥14 days at fair market rent and keep personal use ≤ the greater of 14 days or 10% of days rented. IRS
  2. Then do a 1031 into Georgia rentals (you can buy more than one using the 3-property or 200% rule). You still cannot use exchange money for your Georgia primary. Legal Information Institute
  3. Numbers if you exchange: Using the earlier example numbers, your net sale price for 1031 purposes is the contract price less selling costs ($1,410,000). Your net equity (cash to QI) would be $1,500,000 – $90,000 – $300,000 = $1,110,000.
    • To fully defer, acquire ≥ $1,410,000 of replacement property value and reinvest all $1,110,000 equity.
    • If you reduce overall debt relative to the property you sold, add cash to offset or you’ll have mortgage boot (taxable). The Tax Adviser
  4. California claw-back: Because you exchanged CA property into GA property, you must file FTB 3840 each year until you eventually recognize the deferred CA-source gain (e.g., when the GA rentals are sold in a taxable sale). Lifetime Paradigm
  5. Later converting a replacement rental to your home: You generally must hold it ≥5 years before a future Sec. 121 exclusion can apply, and the exclusion is prorated to remove nonqualified use periods after 2008. FirstExchangeLegal Information Institute

Buying more than one property with a 1031 (for rentals)

  • Use the 3-property rule to identify up to three GA rentals of any value; or the 200% rule to identify more than three as long as the total value you identify is ≤200% of what you sold. Close on enough of them within 180 days to hit your value/equity targets. Legal Information Institute

What happens when Loan & Minh pass away?

  • Step-up in basis: Heirs generally receive a fair-market-value basis at death under IRC §1014. That wipes out prior unrealized gains, including gain deferred by prior 1031 exchanges (the built-in gain disappears when basis steps up). Legal Information Institute+1
  • Community property bonus: Because California is community property, both halves of community property typically receive a basis step-up at the first spouse’s death (if still community property). IRS
  • Estate vs. capital gains: Your children don’t pay capital gains tax just to inherit. If/when they sell later, they owe capital gains only on appreciation after the stepped-up basis date. Estate tax is separate and applies only if your taxable estate exceeds the federal exemption ($13.99M per person in 2025; portable for married couples). California and Georgia do not have their own estate or inheritance taxes. Tax FoundationDepartment of Revenue

Putting it all together (decision flow)

  • If the CA property is/was your main home:
    Use Sec. 121 (up to $500k gain exclusion MFJ). Pay tax on any remainder. Buy your GA primary and GA rental(s) with the proceeds. No 1031 on a personal residence. IRS
  • If/when the property is truly an investment:
    Execute a 1031 via QI to acquire multiple GA rentals, observing the 45/180 day rules, identification rules, and value/equity/debt requirements. File Form 8824 (federal) and FTB 3840 annually if you moved CA gain out of state. Buy your GA primary with non-exchange money. IRSLegal Information InstituteLifetime Paradigm

Quick Takeaways for Loan & Minh

  • You can’t 1031 a primary residence; claim Sec. 121 and plan your GA purchases.
  • If you want full deferral beyond the $500k exclusion, convert to rental first (mind the safe harbor), then 1031 into multiple GA rentals—and buy your GA home separately with non-exchange funds.
  • At death, heirs get a step-up; they don’t owe capital gains to inherit, and there’s no CA/GA state estate or inheritance tax (federal estate tax only above the large federal threshold). Legal Information InstituteTax Foundation

This is educational, not tax advice. Given the dollar amounts, have a CPA/EA and a qualified intermediary review your exact basis, timelines, and state filings (especially California Form 3840 if you ever 1031 from CA to GA).

-Phan Trần Hương-

Sources & Further Reading

  • IRS Publication 523 – Selling Your Home (Sec. 121 rules & worksheets). IRS
  • 26 U.S.C. §121 (home-sale exclusion; nonqualified use & 5-year rules). Legal Information Institute
  • IRS Publication 544 / Form 8824 (like-kind exchange reporting & concepts). IRS
  • Treas. Reg. §1.1031(k)-1 (45/180-day deadlines; 3-property/200%/95% rules). Legal Information Institute
  • Rev. Proc. 2005-14 (coordinating Sec. 121 and 1031 for mixed-use cases). API Exchange
  • Rev. Proc. 2008-16 (safe harbor for converting dwelling units to/from rentals for 1031). IRS
  • IRS final regs defining “real property” for 1031 (T.D. 9935). IRS
  • FTB: Reporting Like-Kind Exchanges & Form 3840 (CA claw-back). Lifetime Paradigm
  • FTB residency & CA-source income (sale of CA real property). Franchise Tax Board
  • IRC §1014; IRS Pub. 551 (step-up in basis at death). Legal Information InstituteIRS
  • Federal estate tax exemption for 2025 (IRS inflation adjustments).