The Tax Benefits of Section 121 and 1031 Exchanges

In the world of real estate investing, tax strategy can make all the difference. From leveraging the home sale exclusion (Section 121) and combining it with a 1031 exchange, to navigating more complex techniques like construction/improvement exchanges and partnership divisions, the opportunities to save on taxes are vast—if you know what you’re doing.

In this episode, we’ll explore advanced tax planning strategies shared by Matt Rappaport, a partner at a rapidly expanding law firm specializing in real estate tax planning. From his perspective as a seasoned tax attorney, we’ll dig into key considerations and opportunities for proactive tax planning that can boost your long-term returns.

Meet the Expert: Matt Rappaport

Matt Rappaport is a founding partner and Vice Managing Partner at Falcon Rappaport & Berkman, a fast-growing law firm that has scaled from just a few attorneys in two offices to about 70 lawyers across multiple states. He heads a robust tax department advising on everything from 1031 exchanges and Opportunity Zones to estate and gift planning, as well as audits and controversies.

Combining Section 121 and 1031 Exchanges

The Opportunity:

Section 121 of the Internal Revenue Code provides a home sale exclusion—allowing married couples to exclude up to $500,000 of gain ($250,000 for single filers) from the sale of a primary residence. Meanwhile, Section 1031 allows you to defer tax on like-kind exchanges of investment property.

The Strategy:

If you convert a former primary residence into a rental property, you may qualify to combine both benefits. Here’s how it generally works:

• Establish Primary Residence Use:
  Use the property as your primary residence for at least two of the last five years before selling.
• Conversion to Rental:
  After moving out, rent the property. You must sell it before it stops qualifying under the 2-out-of-5-year rule (typically no more than three years after you move out).
• At the Time of Sale:
  Apply the home sale exclusion first. This allows you to take up to $500,000 of gain (for married couples) tax-free. The remainder of the proceeds can then be invested through a 1031 exchange, deferring tax on the rest of the gain into a new investment property.

Key Considerations:

• You must follow the 2-out-of-5-year primary residence rule carefully.
• The sequence matters: claim your Section 121 exclusion first, then execute the 1031 exchange.
• Always adhere to strict 1031 protocols, such as using a qualified intermediary (QI).

Beware of High-Risk “Creative” Strategies

Some investors discover questionable techniques online—such as selling a home to their own S corporation to lock in the home sale exclusion while converting the property to a rental.

According to Matt Rappaport, this approach is high-risk and likely to draw IRS scrutiny. The complexity, formalities, and business-purpose requirements are difficult to satisfy, and the potential controversy isn’t worth it for most investors.

If it seems too good to be true or you found it on social media without corroboration, proceed with extreme caution.

Construction/Improvement Exchanges Under 1031

Why Do It?

Standard 1031 exchanges let you defer tax on swaps of investment property. Construction or improvement exchanges take this a step further, allowing you to use 1031 funds not only to acquire a replacement property but also to improve it.

How It Works:

A construction/improvement exchange typically involves a reverse exchange structure. The replacement property is parked with an Exchange Accommodation Titleholder (EAT) set up by your QI. You have 180 days in a safe harbor scenario to complete improvements before the property is transferred to you. Non-safe harbor strategies can take longer but come with additional risk.

Key Points:

• Safe Harbor vs. Non-Safe Harbor:
  Safe harbor improvement exchanges are done within 180 days. Non-safe harbor exchanges can extend beyond that, but you risk a potential challenge by the IRS.
• Timing & Control:
  Reverse improvement exchanges (buying first, then selling) can give more flexibility and time, reducing risk if there are delays.
• Team Coordination:
  Your general contractor must understand the 180-day deadline. Delays can jeopardize the entire strategy.

Partnership Divisions: An Alternative to Drop-and-Swap

“Drop and swap” strategies—where partners in a multi-member LLC take property distributions before doing individual 1031 exchanges—are often on shaky ground. Instead, Rappaport suggests considering partnership divisions. By dividing a single partnership into multiple partnerships, each considered a continuation of the original, you can preserve the integrity of the 1031 exchange and sidestep common technical challenges.

With a properly structured partnership division, you can achieve results similar to a drop-and-swap without the same level of scrutiny or risk of IRS attack.

Dealing with S Corporations

Investors who own highly appreciated real estate in S corporations can find themselves “stuck” due to complicated tax consequences when moving property out. While sophisticated tactics like 721 contributions into a REIT structure or long-term planning through preferred partnership freezes exist, they are complex and typically only worthwhile for very large holdings.

Final Thoughts

Navigating real estate tax strategies demands expertise and careful structuring. Whether combining a Section 121 exclusion with a 1031 exchange, executing a construction/improvement exchange, exploring partnership divisions, or grappling with an S corporation’s constraints, proper guidance is essential.

Next Steps:

• Consult with a qualified tax attorney or CPA before implementing advanced strategies.
• Ensure your QI and other transaction partners are well-versed in these techniques.
• Focus on transparency, robust formalities, and genuine business purposes to ensure tax advantages withstand scrutiny.

By understanding these complex strategies and working with seasoned professionals like Matt Rappaport, you can optimize your real estate portfolio’s tax position, protect your wealth, and set the stage for sustainable long-term success.

Transcript

Intro (0:00)

Thomas: You’re now listening to the Tax Smart REI Podcast, the number one tax podcast for real estate investors. Hey Matt, thanks again for joining us on the show today. I know it’s been a while since your first appearance on episode 75, where we talked about drop and swaps pretty in depth.

Matt: What episode is this?

Thomas: This is going to be episode, I think, 286 or something like that.

Matt: That’s a long time ago, man.

Thomas: Yeah, we have to have you back more often.

Matt: That’s all right, happy to do it. You just say the word.

Matt’s Background and Firm Overview (1:07)

Thomas: For those listeners who have not heard that previous episode or don’t know who you are, could you give them a brief overview of your background and how you help real estate investors?

Matt: Yeah, I fell off the turnip truck and they gave me a law license. What’s my background? I’m one of the founding partners and the second-ranking guy—sort of—at Falcon Rappaport & Berkman. I’m the Vice Managing Partner. We founded the firm about six years ago. Now we’re about 70 lawyers. Last time I was on your podcast, we had just a couple of offices. Now we have offices in Manhattan, Long Island, Westchester County, Boca Raton, Florida, Newport Beach, California, and a few satellites in San Francisco, New Jersey, and Chicago. It’s been crazy growth.
I head up the tax department. Back then, it was just me and maybe one associate. Now we have about a dozen people in the tax department. I can’t even say I speak for the entire firm anymore—just for myself—since we have multiple co-heads and of counsel attorneys who have their own views.
What do we do to help people? We’re tax planners. We help with structuring and, when needed, compliance and controversies. On real estate transactions, we assist in tax-motivated planning—1031 exchanges, Opportunity Zones, fund formation, passive activity rules under Section 469, depreciation, Section 179 expensing, and so forth. We do estate and gift tax planning as well—family limited partnerships, GRATS, SLATs, charitable planning—and we handle audits and controversies related to all these areas. We often partner with firms like Hall CPA, who do great work in this space.

Thomas (1:46): Thank you, Matt. Every time we speak with you, it’s amazing. You go in-depth. I know 1031 exchanges—

Matt: You got to tell my wife that. She says I blabber on all the time and doesn’t understand what I’m talking about. Tell her to listen to the five-minute mark of this episode!
[Laughter]

Combining Section 121 Home Sale Exclusion with a 1031 Exchange (5:13)

Thomas: I know 1031 exchanges are one of your areas of expertise. We have clients who buy highly appreciated properties—often in California or New York—they live in them for a while and then move out and start renting them. These properties keep appreciating. They might be eligible for the home sale exclusion (up to $500,000 if married), and then they want to do a 1031 exchange if it’s still a rental. Is that something you come across often?

Matt: Maybe about twice a year. It’s a cool strategy, and it’s allowed by the rules. The government has guidance on how to handle these situations. You’re not breaking the law, but there are nuances.

Section 121 says you must have used the property as your primary residence for two out of the previous five years to qualify for the exclusion. If you want to combine Section 121 and 1031, the order matters. You need the property to have qualified use for 121 first—so you get that exclusion—and then at the time of sale, it must qualify for 1031. You typically can’t have rented it out for more than three years after you move out, or you lose the 121 benefit.

If you follow the rules, you can take out, say, $500,000 tax-free, treat that as non-taxable boot, and then 1031 exchange the remainder. Just remember to follow all 1031 formalities, use a qualified intermediary, and don’t take constructive receipt of the funds.

Questionable Strategy: Selling to an S-Corp to “Lock In” the 121 Exclusion (10:56)

Thomas: We’ve also heard of a strategy—never done it myself—where if your residence exceeds the amount of the exclusion or you’re about to lose the timing, you sell your property to an S corporation to lock in that home sale exclusion while still keeping it as a rental. Have you seen that?

Matt: This is the first time I’m hearing of it. Off the cuff, it sounds tricky. You’d need a bona fide sale, proper seeding of capital in the S corp, and a legitimate business purpose. Otherwise, the IRS might argue it’s not a real sale, just a disguised contribution. The optics aren’t great, and an auditor might say, “Come on, this doesn’t look right.”

You need a high-risk tolerance. I wouldn’t recommend it. Maybe if you did it perfectly, but I’d steer clear because it’s just not a solid plan.

Construction / Improvement Exchanges (21:49)

Ryan: Let’s move on to construction or improvement exchanges. We get a lot of questions about them. Why would someone want to use one to begin with?

Matt: If you want to use 1031 money not just to buy replacement property but also to build or improve it, you need a construction (or improvement) exchange. A standard deferred exchange doesn’t let you use the proceeds for improvements.

You must set up a “parking exchange” through a Qualified Exchange Accommodation Agreement (QEAA) and an Exchange Accommodation Titleholder (EAT). The EAT, a single-member LLC owned by the Qualified Intermediary, takes title to the property. This lets you construct improvements during the exchange period.

Timing is critical. Safe harbor is 180 days. If it’s a forward improvement exchange, that can be tough because all improvements have to be done in that period. A reverse improvement exchange can give you more control because you can acquire first through the EAT, then sell your relinquished property, giving you the full 180 days.

Non-Safe Harbor 1031 Exchanges and the Bartell Case (Approx. 32:00)

Matt: So far, I’ve referred to the safe harbor period, which is 180 days. If you do a reverse construction exchange under the IRS safe harbor, you have that strict timeline. But what if you need more time?
There was a Tax Court decision in 2016, called the Bartell case, which allowed a non-safe harbor reverse exchange that lasted longer than 180 days. The Tax Court sided with the taxpayer, basically saying that if structured correctly, you could go beyond the safe harbor period.

Thomas: So does that mean we can always just exceed 180 days?

Matt: Not exactly. After Bartell, the IRS stated they disagree with the outcome and would challenge it again if it comes up. But Bartell is still a Tax Court case, which means it’s precedent the IRS can’t just ignore. This creates an opening for non-safe harbor exchanges where you can take longer than 180 days—if you structure it properly. Just understand you’re taking on more risk. The IRS might push back, and you should be ready for controversy or even litigation. Still, Bartell gives you a tool if circumstances demand more than the standard timeline.

Ryan: So if someone needs more than 180 days, they can try this approach, but it’s risky?

Matt: Exactly. Non-safe harbor exchanges post-Bartell are possible but come with greater risk than standard safe harbor exchanges. It’s a powerful option, but one that should be approached carefully and with the advice of a qualified professional.

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Other Creative 1031 Strategies (31:03)

Ryan: That’s a good strategy for certain people. Is there anything else unique beyond the safe harbor and these standard strategies?

Matt: Partnership divisions are really nifty. Instead of a drop and swap, you can divide a partnership into multiple partnerships. Each resulting partnership is treated as a continuation for federal tax purposes, which makes it harder for the IRS to argue it’s a different taxpayer. You can do these divisions pre-sale, mid-exchange, or post-exchange. I’m doing a dozen or more of these a year now.
For S corporations, it’s tougher. Long-term planning might involve 721 exchanges into DSTs that eventually convert into REITs. But that’s much more complex. Partnerships are easier to work with.

Wrapping Up (46:57)

Thomas: We’re coming up on time. We covered a lot today. It’s always an honor speaking with you and diving into this stuff.

Matt: An honor? Now I really have to tell my wife to listen to the whole episode. She thinks I just blabber, but now you said it’s an honor.

Thomas: If our listeners want to reach out to you, what’s the best way?

Matt: Email only, please. That way I can schedule calls. My email is MER@frblaw.com. The firm is Falcon Rappaport & Berkman. Just shoot me an email.

Thomas: We’ll put that in the show notes. Matt, thanks again for joining us today. We’ll have to have you on again. It’s been too long.

Matt: Anytime, guys. And next time, tell Brandon Hall he’s gotta join too.

Thomas: All right, we’ll bring him on next time.

If you’re interested in deploying the strategies discussed in this episode, feel free to contact us for more information or consultation.

Disclaimer: This podcast summary and transcript were partly generated by AI and may contain some errors or miss key points from the audio recording.