Can I 1031 my rental into a combo primary res / downstairs rental

Question

I'm going to sell my primary residence to buy another. I'm also going to sell my appreciated rental to my son with a 1031. I see a house where I could do a hack - living upstairs and using the downstairs for a LT or ST rental. Can I do a 1031 exchange into that somehow?

Rob Bailey · Answer

Thanks for the great explanation. It all seems clear to me now. Unfortunately, I'm stopped at the valuation - my walk-out won't pass the valuation test. But now I know! Thanks again.

Bob B. · Answer

@Dave Foster will be along in a little while to give you the experts answer.

Rob Bailey · Answer

The new primary was more than we were wanting to spend but thought about renting out the walk-out basement to cover the extra cost.

Dave Foster · Answer

@Rob Bailey, Appreciate the shout out from Dos Bobs (@Bob B.and @Bob E.).   I think your scenario could be made to work.  First of all that primary sale of yours has no reinvestment requirements so the profit is tax free up to $250K if single, or $500K if married.  So lets just take that out of the equation for a minute.

Your 1031 has to be investment real estate for investment real estate of any type.  And in order to defer all tax you must purchase at least as much as your net sale. That's where this potential hack property could work.

If your 1031 sale was $300K you would need to purchase at least $300K of new investment real estate.  But that could be 50% of a $600K property where you live in 50% and rent 50%.

It's all about the percentages.  But there's a lot you could do here getting preferential financing, and keeping your tax free dollars from your primary sale.  Oh and by the way, when you later sell this new property you'll be able to take the primary residence exemption again on the part you live in.  And you'll get to again do a 1031 on the investment portion.

Nice scenario.

Dave Foster · Answer

@Rob Bailey, You can't exchange into improvements on property you already own without a complex and expensive reverse exchange.  And that would disrupt your advantageous financing.  So you could exchange into the lower unit and the land that will accommodate the ADU (that's a very interesting developing accounting issue in places now allowing them).

Or you could buy the lower unit as your primary initially.  Those ratios might fit your 1031.  And then once the adu is built move into the upstairs and have two rentals.

Rob Bailey · Answer

Thanks Dave!

I imagine that if I get a downstairs type rental (and I live upstairs), the valuation of the 1031 piece would have to go by square footage. If I found a place with enough property that I could build and ADU, can I somehow do that? Or does the exchange have to be for something already built?

Bob E. · Answer

I am going to bet that you would have to consider the value of the part of the property you live in as boot.  So likely this will not be a great strategy for you.  let's see what @Dave Foster says....

This sounds like two transactions.  1) selling your primary and 2) selling an investment property.

Why not use the funds from your primary to buy the house hack and 1031 the funds from the sale to your sone into something new.?

Rob Bailey · Answer

Good to know. As it is, I decided to pass on the property with the potential AirBnB basement. It wasn't what it was advertised to be.

Thanks again.

Dave Foster · Answer

@Rob Bailey, Don't forget it doesn't have to be 1 for 1.  You could purchase second property to make up the short fall.  Of if the valuation was close you could also simply do a partial exchange and pay tax only on the difference.

Dave Foster · Answer

@Rob Bailey, The primary sale can wait.  If you meet the 121 criteria the first $250K of profit ($500K if married) will be tax free whenever you sell.  And you can use that to pay your note down with no problem.

The 1031 side of things is more urgent.  You must close the sale of your old property before you take title to your new property.  So if you want to do a 1031 you'll have to hurry and get that sold.

Beyond that, you have to really watch your valuations - In the 1031 you need to take title to at least as much real estate as you sell.  You can buy a mixed use property.  But the portion you will use for investment has to be equal or greater than the portion you'll be living in if you want to defer all tax.

Lastly you want to check on lending.  Literally until today I had never seen a lender who would lend with 5% down primary financing when the down payment came from a 1031 account.  But today I had a client with a lender who would.   For 1031 purposes it doesn't matter what type of lending you get.  What matters is the use of the property. But most lenders will balk at lending primary residence money to you if you are accessing a 1031 for the down payment.  So really put your lenders feet to the fire on that.

Don't forget that your QI for the 1031 has to be in place prior to the closing of the sale of your old property.

Can I 1031 my rental into a combo primary res / downstairs rental

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