The “Great Tax Break” explained - by Michele Fitzpatrick

The housing market is facing a critical inventory shortage, leaving many young families and first-time homebuyers completely locked out of homeownership. Surprisingly, a major cause of this logjam is an outdated tax law that has not changed since 1997. For nearly three decades, property values across the country have soared, yet the primary residence tax exemption has remained firmly frozen. This cap penalizes long-term homeowners and traps senior citizens in houses that no longer fit their needs.

Fortunately, there is growing legislative momentum to fix this problem. Representative Nicole Malliotakis (R-N.Y.) has championed a crucial proposal to raise the profit exclusion limit to $1 million for homeowners aged 65 or older who have held their property for at least 25 years. This proposed three-year tax holiday would lift a massive financial burden off older Americans, motivating them to downsize and finally free up heavily restricted housing inventory.

By upgrading these outdated limits and combining the Section 121 primary residence exclusion with a Section 1031 investment exchange, we can unlock the housing market, support novice investors, and generate the rental inventory our communities desperately need.

The Broken Link in the Housing Supply Chain: Under the current rules of Internal Revenue Code Section 121, an individual can exclude up to $250,000 – and a married couple can exclude up to $500,000 – of profit from the sale of their primary residence. While that sounded like a lot of money in 1997, decades of real estate appreciation have vastly outpaced these figures.

Today, a senior couple who bought their family home thirty years ago for a modest price might find that it is now worth well over $1 million. If they decide to sell and downsize to a smaller condo, they face an enormous capital gains tax bill on any profit over the $500,000 threshold. As a result, many seniors simply choose not to sell. They stay in large, single-family homes that they no longer want to maintain, creating a massive inventory bottleneck. Passing the new legislative proposal would eliminate this penalty. By raising the exclusion limit to $1 million, Congress can incentivize millions of seniors to put their homes on the market, creating an immediate wave of available housing stock for younger families eager to buy.

Understanding the Double Tax Advantage: For everyday people looking to build long-term security, understanding how the tax code works is the first step toward building real financial momentum. The IRS allows homeowners to combine two completely different tax benefits on a single property. This strategy is known as the “Great Tax Break,” and it blends the Section 121 primary residence exclusion with a Section 1031 like-kind exchange.

Section 121 allows owners to take tax-free cash out of their principal home, provided they have lived in it for an aggregate of two out of the past five years. On the flip side, Section 1031 allows an owner to sell an investment or rental property and defer paying capital gains taxes entirely, as long as the proceeds are reinvested into another investment property of equal or greater value.

When these two rules are combined, it allows for an owner to pull tax-free cash out of their home while simultaneously building up a rental property portfolio that helps solve the local housing shortage.

Strategy 1: The Primary-to-Investment Conversion

Imagine a young couple who bought a starter home several years ago for $250,000. Over time, the neighborhood boomed, and the home is now worth $1,250,000. If they sell it outright, their $1 million profit exceeds their $500,000 married exclusion limit, leaving them with a massive tax bill on the remaining $500,000. Instead of panic-selling, they can convert the home into a rental property. By moving out and renting the house to a tenant for two years, the property changes from a primary residence into an income-producing investment asset. Because they lived in the home for two out of the past five years, they still qualify for their Section 121 exemption, allowing them to pocket $500,000 entirely tax-free. At the same time, because the property was a rental for the last two years, they can execute a Section 1031 exchange on the remaining value. They can take that equity and purchase new investment properties to rent out to other families. They pay zero immediate taxes, unlock cash for their own family, and create stable rental options for the community.

Strategy 2: Unlocking Mixed-Use and Multi-Unit Properties

Another common way to use this strategy is with a multi-unit property, such as a duplex, a home with an accessory dwelling unit (ADU), or a garage apartment.

Consider a couple who owns a traditional two-family duplex. They live in one half as their primary residence and rent out the other half to a tenant. When it comes time to sell, the IRS treats this as a “mixed-use” property. The half they live in qualifies for the Section 121 tax-free cash exclusion, while the rental half qualifies for a Section 1031 tax deferral.

Upon selling, they can safely put their primary residence gains into their personal savings or use them to buy a new single-family home. Meanwhile, they can roll the rental portion of the profit directly into a replacement multi-family property using a 1031 exchange. This keeps money out of the hands of the tax collector and puts it right back into the community by maintaining and expanding affordable housing options.

How to Safely Navigate the Process

While these strategies are highly effective, the IRS enforces strict rules when executing a 1031 Exchange:

• The 45-Day Rule: The exchanger must formally identify up to three potential replacement investment properties within 45 days of selling their original property.

• The 180-Day Rule: The exchanger must completely close on the purchase of their new replacement properties within 180 days of their original sale.

• No Direct Funds: The proceeds from the sale cannot be touched directly by the exchanger. If the funds are deposited into their personal bank account, the tax break is canceled.

To keep the transaction safe, an exchanger must partner with an independent partner known as a Qualified Intermediary (QI) before their sale closes. Companies like Northern 1031 Exchange act as a safe harbor, holding your funds in escrow and guiding you through every deadline to guarantee a seamless, tax-deferred transition.

Michele Fitzpatrick is the 1031 Exchange relationship manager, vice president at Northern Bank, Woburn, Mass. 

*Northern Bank, including its subsidiary Northern 1031 Exchange, LLC does not provide tax, legal or accounting advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. We strongly encourage you to seek appropriate professional advice regarding your specific facts and circumstances