1031 Exchanges & Mixed-Use Properties

5 Replies

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.

@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.  

@Stanley Parsley The LLC gain would flow to my personal return. Putting the property under either structure activates the clause in my mortgage contract where the bank calls back the loan.

@Dave Foster Thank you for that great advice. So i would have to treat the new property the same ratio 50% residence and 50% Rental investment as I did with the one I sold?

@Mark Rueda , it's actually a little better than that.  You need to pay attention to your reinvestment requirements as allocated when you sell but your purchase doesn't have to conform to a strict %.  It is by dollar amount.

Example - You sell a duplex that is 50% investment and 50% primary residence for $300K.  50% or $150K go into your exchange.  50% or %150K comes to you tax free. When you purchase you must purchase at least $150K in investment property if you want to avoid all tax. You could buy a 4 plex for $600K and use 25% or $150K for your primary residence and 75% or $450K as investment.  Or vice versa.  Buy a large $600K property and use 25% or $150K for investment and 75% or $450K for your primary.  In both of those examples you sold  $150K of investment property and purchased at least as much as you sold.   

@Dave Foster , that was exactly the answer I was looking for. Thank you Dave I will keep you in mind. This also helped me get a better understanding on the purchasing side and how to treat it for tax purposes. All my investments are made with the tax law in mind since I’m a Tax CPA. Trying to master the 1031 exchange law to help my clients when they file their taxes.

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