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Apologies for the long post. I sold an investment property in late 2002 (house 1) but deferred capital gains taxes by setting up a 1031 exchange. This involved buying a house in Brooklyn (house 2) that I rented out for about two years to complete the exchange. Since then I have lived in house 2 as my primary residence. The plan was to live in it for at least two years then sell it using Code 121 in 2006 or 7. As I understood it, when I sold house 2 as my primary residence, I wouldn't have to pay capital gains tax from the sale of the house 1, which would disappear, and I would not have to pay capital gains taxes on the sale of house 2 up to 250,000 (as allowable for a single person). I'm a grad student with minimal financial background and inherited house 1 when one of my parents passed away; I've made some relatively big decisions in the past few years to fit this plan. I would really like to sell the house at this point.

Unfortunately I recently learned that in 2004 the tax laws changed and to combine a 1031 exchange and Code 121 in this way – to buy an investment property as part of a 1031 exchange then convert it to a primary residence and sell it as such – requires that one own the property for a minimum of 5 years. A thread from 10/30/2004 titled “Change in 1031 exchange law?” concerns this change.

I'm looking for a new accountant knowledgeable about 1031 exchanges, and will of course consult with them. I am also trying to learn what I can on my own. It looks like if I want to benefit from both 1031 and 121 I must hold onto the property until the 5 years is up. Another option is to convert it back to an investment property by renting it out for about another year then do another 1031 exchange.

Here's my question: if I want to pay capital gains taxes on house 1 and in a sense "undo" the 1031 exchange, is that possible and could I then sell it as my primary residence and benefit from 121 since I've lived in it for more than 2 years? Both houses have appreciated significantly but the gain from house 2 would be larger than on house 1, and proceeds resulting from this convoluted series of events would finally be available to me without strings. This third choice would seem preferable if it is in fact an option.
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