1031 Exchanges & Mixed-Use Properties

[Mark Rueda]

I own a two-family home where I live on the second floor and rent out the 1st floor. For tax purposes I made my principal residence 50% and rental investment 50%. I have been depreciating half of the homes cost basis against the rental income. The home has appreciated enough to the point that I would like to upgrade and try to manage 4 units. I will live in one and rent out the other three. When I preform a 1031 like-kind exchange I know I will be able to use the section 121 capital gain exemption on the sale of my principal residence on half of the sales price up to $250,000 of gain. I also know that this 1031exchange is a 2-step process where you sale the property first and then you buy the new one. My question is when I sell my home and claim the section 121 exemption will the new property have the carry over basis of my investment portion of the property and then at that point can I allocate the basis to the new layout for depreciating 3/4 of the property since I will be living in 1 unit? Is the purchase of the new property like a fresh start where I now decide what portion will be my principal residence and what portion will be rental? I'm hoping to repeat this process every 3 to 5 years to take advantage of section 121 and keep upgrading into a bigger and better property. Any help or advice is appreciated. Thank you.

[Dave Foster]

@Mark Rueda, that is a great question and strategy!!  Some of this is timing.  But I think there's a way structurally to make the allocations easier.

When you sell a split use property the allocations are not always clear such as when you've used part as a primary residence for a period of time and then change the allocations, use and duration.  There's a couple different ways to handle.  Your accountant will be the deciding factor

1. At the sale of the old property you will start a 1031 exchange but will take boot equal to the amount of your primary residence exclusion.  This would normally be taxable but because you qualify for 121 your accountant puts that exemption against the boot.

2. Or you will start your 1031 on the allocated portion that is being used as investment.  The remainder would fall under 121 up to the limits of 121.

Option 1 is probably the best for you.  And when you get into the swing of buying and moving in then moving out and turning in the same sq footage into investment it will serve you well.