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Many thanks. It's too bad the 1031 treatment is not optional at this point. I'd have chosen to "undo" the exchange set up in 2002 and just benefit from Code 121 by selling house 2 as promary residence now.

When I mentioned that "both houses have appreciated significantly" I was trying to say that the capital gains tax on the sale of house 1 in 2002 and the hypothetical sale of house 2 this year would be high, since both houses increased a lot in value, but I would rather pay the capital gains taxes on house 1 if that would mean avoiding them on house 2, because the former would be lower.

Anyway, what a mess! I'm looking for someone who specializes in these issues, and as you pointed out it might be even worth looking back to check what the basis of house 1 was since I inherited it when my mother passed away. I made this plan based on the tax advise I was given then, but now realize the cpa might not have been up to speed, and certainly did not bother to get in touch about the 2004 law changes.

It's looking like the best option may be to hold on unti the 5 years is up then sell it and disentangle myself! I certainly hope the laws don't change again to make this combination more difficult or impossible.

Thanks again,
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