Can I 1031 Exchange a rental for a primary with an ADU?

Question

Hey, question for anyone familiar with 1031 exchanges. I have a rental property I’ve held since 2019 that I’m considering selling. Would I be able to do a 1031 if I’m buying a primary property with an ADU that I would use as a short term rental? I read somewhere I could 1031 the portion of the property that I’m renting (ADU), and pay capital gains tax as normal on the portion I’m living in? Is something like this possible? Let me know if you need more info. Thanks!

Dave Foster · Answer

@Nick Sansivero, Spot on by @Bill B..  You're talking about a mixed use property.  Your accountant will make the allocations.  But only the portion of the purchase allocated to investment (the adu) can be used to satisfy your 1031.

Ashish Acharya · Answer

Yes, it's possible to use a 1031 exchange for the portion of the property that will be rented out, like the ADU in your case. You can defer capital gains taxes on the ADU through the 1031 exchange, while the portion of the property you’ll use as your primary residence would not qualify and would be subject to capital gains tax as usual. Just make sure to properly allocate the purchase price between the rental and residential portions and keep clear records. Consulting with a tax professional who understands 1031 exchanges is a good idea to ensure everything is handled correctly.

Bill B. · Answer

You can buy an ADU with your 1031 exchange, but only the portion of the total price the ADU is worth would be considered the exchange. AND, you don’t save a pro-rated portion of the taxes, any amount of your exchange over the ADU value would be 100% taxable.

So the ADU would have be worth pretty much the total of your exchange. IE. You do a $500k exchange with a $200k gain. You buy a $800k home with a $300k ADU. You didn’t save any taxes, you still owe taxes on $500k minus $300k, or $200k.

Ps. Remember you are only deferring the taxes, not eliminating them. So if you ever moved that portion of your otherwise tax free primwry home sale would now become taxable. Plus you would owe all the taxes and depreciation recapture you deferred. Thai could end up costing you more in taxes. (The primary home appreciation of the ADU not being tax exempt.) than you save today with the 1031.

Mike Savage · Answer

@Nick Sansivero

Terrific question and timely for us.  We have been considering selling our recently vacant first owned home that has been a rental for 20 years.  Our good friends have a wonderful primary w an exceptional ADU on it.  Here are some numbers. Our first property purchased February 2000 for $195k likely worth $575k.

Our Friends house w ADU worth approximately 1.8mil however the exceptional ADU was built by best builder in region for $300k and would cost $500k to build today.  We have been considering selling our primary after living here 18 years and just thought what if we sold our primary and 1031 our rental into our friends house at the same time we sell our primary?   We love their home and could travel while having income from either the main property or ADU meaning we could move into the ADU while away for extended time.

Jim Fong · Answer

Nick,

Why can't you buy the house as a "rental" and then when you are not able to rent it out easily and then you can move into the main house and rent out the ADU.  I think the house would be considered a primary after that.  You should get more info on what would happen when you sell this in the future though.

Can I 1031 Exchange a rental for a primary with an ADU?

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