Section 121 vs 1031 Exchange
Two of the largest US real-estate tax preferences. Section 121 permanently excludes up to $250k / $500k of gain on a primary residence. Section 1031 defers unlimited gain on investment property by rolling it into a replacement. The two can be combined on dual-use property.
Side-by-side comparison
| Feature | Section 121 (Home Sale) | Section 1031 (Like-Kind Exchange) |
|---|---|---|
| Tax effect | Permanent exclusion | Deferral (basis carries forward) |
| Eligible property | Primary residence only | Investment / business real property |
| Cap on gain | $250k single / $500k MFJ | Unlimited |
| Holding-period requirement | Own + use 2 of last 5 years | Held for investment (no fixed minimum, but ~2 yrs is safe harbor) |
| Frequency limit | Once every 2 years | Unlimited (chain forever) |
| Replacement property required? | No — cash out | Yes — must close within 180 days |
| Identification window | N/A | 45 days from sale (in writing) |
| Qualified intermediary required? | No | Yes — cannot touch sale proceeds |
| Depreciation recapture treatment | Not excluded — taxed at up to 25% | Deferred into replacement basis |
| Step-up at death | Not relevant (gain already excluded) | Wipes out all deferred gain (key strategy) |
| Filing form | Form 1040 + Schedule D / Form 8949 if exclusion exceeded | Form 8824 (Like-Kind Exchanges) |
Worked example: $700,000 gain on a former-residence rental
A married couple owns a property they used as their primary residence for 5 years, then converted to rental for 3 years (taking $40,000 of cumulative depreciation). They sell for a $700,000 total gain. Compare three strategies — straight sale, Section 121 only, and Section 121 + 1031 combined per Rev. Proc. 2005-14:
| Strategy | Gain excluded | Gain deferred (1031) | Taxable now | Tax owed (20% LTCG + 25% recapture + 3.8% NIIT) |
|---|---|---|---|---|
| Straight sale (no Sec 121, no 1031) | $0 | $0 | $700,000 + $40k recapture | ~$178,000 |
| Section 121 only | $500,000 | $0 | $200,000 + $40k recapture | ~$59,000 |
| Section 121 + 1031 combined | $500,000 | $200,000 + $40k recapture | $0 | $0 today (deferred into replacement) |
Assumes the couple is in the top 20% long-term capital gains bracket (single filers: taxable income over $533,400 for 2025; MFJ: over $600,050) plus the 3.8% Net Investment Income Tax on the full gain, and the $40,000 of post-May-1997 depreciation is taxed as unrecaptured §1250 gain at the 25% cap. Filers in a lower LTCG bracket (0% or 15%) would owe less. The combined strategy requires identifying replacement investment property within 45 days of the rental-property sale and closing within 180 days. The depreciation recapture stays as recapture in the new property — a future sale (without another 1031) brings it back at 25%. If held until death, the heirs' step-up wipes it out entirely.
Frequently asked questions
What's the headline difference between Section 121 and 1031?
Section 121 is a permanent exclusion of up to $250,000 ($500,000 MFJ) of gain on the sale of a primary residence — the gain disappears forever. Section 1031 is unlimited deferral (not exclusion) of gain on the exchange of investment or business real property — tax is owed eventually, but pushed forward into the basis of the replacement property.
What property qualifies for Section 121?
Only your primary residence — the home you have owned AND used as your main home for at least 2 of the last 5 years before sale (the "ownership and use tests"). The two periods don't have to overlap. Vacation homes, rental properties, and second homes do not qualify. Married couples can each separately meet the use test (jointly the ownership test) to claim the full $500,000 MFJ exclusion.
What property qualifies for Section 1031?
Real property held for investment or use in a trade or business — rental homes, commercial buildings, raw land, leaseholds (30+ years remaining). Personal residences, inventory, and stocks/bonds/partnership interests are excluded. Before the TCJA (2018), Section 1031 also covered PERSONAL property like equipment, vehicles, franchise licenses, and aircraft — the TCJA repealed that entirely, so since January 1, 2018 only real property qualifies. The Form 8824 like-kind requirement is broad for real estate — any real property exchanged for any other real property in the US qualifies (one apartment building for raw land + warehouses is fine).
What is the 2-of-5-year rule for Section 121?
You must have owned the home for at least 2 of the last 5 years AND used it as your main home for at least 2 of the last 5 years before the sale. The two 2-year periods don't need to be the same 2 years and don't have to be continuous. You can claim full Section 121 once every 2 years. Partial exclusions are available for sale due to a change in employment, health, or unforeseen circumstances.
What are the 45-day and 180-day rules in 1031?
After selling the relinquished property, you have 45 calendar days to identify potential replacement properties in writing to a qualified intermediary, and 180 calendar days (or your tax-return due date, whichever is earlier) to close on the replacement. Both deadlines are absolute — no weekend/holiday extensions, no IRS waivers. Identification must follow one of three rules: 3-property rule, 200% rule, or 95% rule. See Form 8824 instructions.
Can I combine Section 121 and 1031?
Yes — for property that has served as both a primary residence and a rental, you can layer the two strategies. Rev. Proc. 2005-14 allows you to first apply Section 121 ($250k/$500k exclusion on the residence portion), then defer the remaining gain via 1031 on the investment portion. The classic example: rent out a former primary residence for 1–2 years before selling and 1031-ing into a different rental.
What happens to depreciation recapture?
Section 121 does NOT exclude depreciation recapture on the home — any depreciation taken (e.g., for a home-office or rental period after May 6, 1997) is taxed at up to 25% as unrecaptured Section 1250 gain. Section 1031 fully defers depreciation recapture into the replacement property's basis. If you eventually sell the 1031 replacement without exchanging again, all the cumulative recapture comes due at once — though if you die holding it, your heirs receive a stepped-up basis that wipes out the deferred gain (subject to estate tax).
Which one is better?
They serve different purposes. Section 121 is the only way to permanently eliminate gain on a primary residence — use it whenever you sell. Section 1031 is for investment properties when you want to keep growing real-estate exposure without paying capital-gains tax along the way. Long-term real-estate investors typically chain 1031 exchanges for decades and rely on the step-up at death; short-term homeowners use Section 121 every 2 years.
Try the relevant calculators
- 1031 Exchange Calculator — model deferred gain and replacement-property basis
- Capital Gains Tax Calculator — short-term and long-term gain tax estimate
- Depreciation Calculator — MACRS schedule for rental and commercial
- Rental Income Tax — Schedule E with depreciation and passive loss rules
- NIIT Calculator — 3.8% Net Investment Income Tax on real-estate gain
- Estate Tax Calculator — federal estate tax + unified credit at death
- Property Tax Calculator — annual property tax by state