Can I 1031 exchange a duplex if I live in 1 unit (my tenant lives in the other)?

Question

I built an ADU in LA and live in the front house. The former garage is now a single apartment and has been rented out to my tenant since 2021. the ADU is legal -  was built with all the permits and has a CoO - and has its own separate address.  (CoO is critical in LA).

Questions:

1. Can I do a 1031 exchange on this two unit property if I live in one of the units?

2. If so, when does the 2 year clock start?  I assume it's when the ADU was first rented out.

3. I am renting it out as a furnished long term rental (more than 31 days but less than a year), with back to back tenants.  Not sure if this is an issue.

My goal is to 1031 exchange this into a 3-4 unit property where I occupy one of the units.

Thank you for your guidance.

Dave Foster · Answer

Exactly right @Rick Albert.  @Patricia Galea, when your cpa put that adu into service they allocated a certain 4 amount to the value of the land and structure.  let's say your entire property was purchased for $1. mil.  The front house is 3000 square feet and the adu is 1000 square feet.  Your accountant probably allocated 3/4ths of the value to the front house ($750K) and 1/4th to the adu ($250K).

If that property is now worth $2 mil then $500K of the sales price would be allocated to the adu and 1.5 mil allocated to the sale of your primary residence.

So your 1031 would be for the $500K of the sale.  And your primary residence exclusion would be from the $1.5 allocation.

Patricia Galea · Answer

Thanks Rick,

I am also considering renting out the front house (for a couple years) so that the entire property can eventually be 1031 exchanged.

Patricia Galea · Answer

got it, thank you.

Dave Foster · Answer

@Matt Devincenzo, @Logan M., It's fine to mix and combine both 121 and 1031 as long as the accountant has set up the property so that the investment and primary residence portions have been separated and reported separately on the tax retun.  It's actually a huge benefit for all those folks doing "house hacking" in duplexes and small multifamily properties.

One of those little-known opportunities the IRS is famous for not telling you about.

Logan M. · Answer

Exactly what I was thinking

Patricia Galea · Answer

Thanks Celia, this is very helpful info.

Celia Moore · Answer

1. You can do a 1031 exchange with the portion of your property that is allocated as investment property (the ADU/rental). The portion of the property that is your primary residence would not be eligible to exchange. However, if you have used it as your primary residence for at least 2 out of the last 5 years, you would be eligible for the Section 121 Universal Exclusion of gain for primary residence of up to $250K for an individual or $500K for a married couple filing jointly. The allocation percentages of primary residence versus investment property would be determined by you and your tax counsel.

2. There is no “2-year clock” in a 1031 exchange unless you are exchanging with a related party. The IRS code does not give specific holding periods to qualify for a 1031 so it is a gray area. Generally a holding period of at least one year is long enough to demonstrate your intent to hold that property as an investment (versus for resale) but it really comes down to what you and your tax counsel are comfortable with.

3. The length of rental periods would not affect a 1031 exchange. If your replacement property is another owner-occupied multi-unit property, again only the portion that is held as investment would be part of the 1031 exchange, while the portion that you live in would be treated as your primary residence.

Rick Albert · Answer

It's not a bad option. The only caveat is the main house is subject to Los Angeles Rent Control. Houses with ADUs sell very well as long as everything is delivered vacant.

Mohammed Rahman · Answer

Hey @Patricia Galea - I recommend speaking to your attorney & CPA about this.

As others have mentioned, you're mixing the 1031 along with details of the capital gains exclusion for primary residences.

From what I remember, the 1031 is meant for investment purposes only and so can only be used for investment property.

Good luck!

Rick Albert · Answer

A lot of it has to do with how much gain you have. What Dave is likely referring to is on your tax return, how do you report the rental income? From my understanding you could allocate a percentage of the property towards the next exchange.

Out of curiosity, have you considered keeping it and renting out the entire property and buy the next one? The numbers might make sense to keep it for a minute before selling.

Can I 1031 exchange a duplex if I live in 1 unit (my tenant lives in the other)?

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