Can you 1031 Exchange Into a Multi-Unit Property & Occupy One of the Units?

There are many questions that come up when it comes to 1031 exchanges of investment property. Here’s one that a client asked us recently: can you 1031 exchange into a multi-unit property and occupy one of the units? 

Combining Section 1031 & Section 121

This is a somewhat complicated situation. In an ideal world, you could split the transaction into a part IRC Section 1031 exchange and part IRC Section 121 sale of the principal residence (so you can exclude some or all of the gain from the principal residence).

The 1031 part is the portion or percentage of the property used exclusively for business or rental.

In order for the principal residence part of the property to qualify for the exclusion the part used for principal residence must meet both the: (1) ownership test and the (2) use test. One is eligible for the exclusion if they have owned and used that portion of the property as their main home for a period aggregating at least two years out of the five years prior to its date of sale. One can satisfy the ownership and use tests during different 2-year periods. However, one must meet both tests during the 5-year period ending on the date of the sale. Generally, a person is not eligible for the exclusion if they have excluded the gain from the sale of another home during the two-year period prior to the sale of the home.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2020 Copyright Jeffrey R. Peterson All Rights Reserved

Combining Both Principle Residences & 1031 Exchanges

Per Revenue Ruling 2005-14, partially nontaxable exchanges are allowed under Section 1031 of the Internal Revenue Code for the portion of the real property used for investment or business purposes.  See IRS Publication 544. 

If, in addition to like-kind property (used for used for investment or business purposes), you also dispose of non-qualified property (not used for investment or business purposes), then you must recognize gain or loss on the non-qualified property you sell. The gain or loss is equal to the difference between the fair market value of the non-qualified property and the adjusted basis of the non-qualified property. This portion of the gain may nevertheless be excluded under Section 121 of the Internal Revenue Code for principle residences. Both Sections 1031 and 121 may be applied to the same sale transaction.

Minnesota Qualified Intermediaries

 At CPEC1031, we give each of our clients the individualized attention that they deserve. Our intermediaries have twenty years of experience facilitating 1031 exchanges in the Twin Cities, and throughout the United States! We’ve got all the resources needed to make your 1031 exchange a reality. Reach out to our qualified intermediaries today at our office in downtown Minneapolis.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2019 Copyright Jeffrey R. Peterson All Rights Reserved

Tips for Dealing with 1031 Property Received in a Divorce Settlement

When a spouse purchases property in a 1031 exchange, they have a lower basis (than a normal cost basis) in the property to the extent that they have deferred gains and rolled over into the new replacement property. This may be called a substituted basis or reduced basis due to the taxes that were deferred in the exchange.

Depreciation Deductions

If, in addition to starting with a lowered basis, the spouse then took depreciation deductions for the wear, tear, and exhaustion of the property, then the remaining basis would have been further reduced each year incrementally as these depreciation deductions were taken.

Section 1041

Years later, if the spouse gets divorced and transfers the replacement property to their ex-wife/husband (former spouse) as part of a divorce property settlement, then the former spouse will take the property with a straight carry-over basis under IRC Section 1041 (transfers of property between spouses or incident to divorce), so they get the property with a super low basis, being whatever remaining basis the transferor had left in the property. Section 1041 makes transfers between spouses tax-neutral, in that the receiving spouse just takes the transferred property subject to the other spouses basis.

Section 121 Exclusion

If the former spouse moves into the property and makes it their principle residence, they may be able to take a partial exclusion under IRC Section 121 once they have owned and lived in the property for two years; however, the amount of the exclusion allowed is a fraction based upon the ratio of the time the property was used as a rental and the amount of time it was used as a principle residence. Further, IRC Section 121 is inapplicable to deprecation recapture. So, the former spouse will only get to use a fraction of the principle residence as it relates to the appreciation (or natural increase in value over time), but will not be able to exclude any gains attributable to the past depreciation that was taken by either or both spouses.

Unrecaptured Depreciation

Unrecaptured depreciation may be taxed at a maximum rate of 25% on most US real property. While normal long term capital gains are taxed at a maximum rate of only 20%.

In summary, if you receive property in a divorce property settlement that was originally purchased to complete a 1031 like-kind exchange…you may be receiving the property with an unexpectedly low basis and additional potential tax complications. These tax complication may be compounded by the limitations imposed in Section 121 for the principle residence exclusion that carve-out from the exclusion the deprecation recapture

PROTIP:  Let the entrepreneurial spouse keep the old low basis property, and have the other spouse receive cash!  Cash is king.

• Start Your Exchange: If you have questions about tax implications of property in a divorce, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Case Study: Exchanging a Personal Residence

Recently, a client came to us with the following 1031 scenario. The client was looking to sell their personal current residence and 1031 into something different. They had only lived in the residence for 15 months and didn't plan to live in the replacement property. Is it possible to exchange this property in a 1031 transaction. If so, what are the implications?

Personal Residence Exclusion

Unfortunately, this situation does not qualify for 1031 exchange treatment. A personal residence may not qualify for section 1031 as it has not been used for investment for business purposes. However, there is another tax code section (section 121) that allows for an exclusion of up to $500,000 of gain if you're married or $250,000 if you’re single. That being said, you must have owned and use the property as your primary residence for at least two years.

Partial 121 Exclusion

Interestingly, there are certain exceptions that will permit a partial 121 exclusion in instances where the taxpayer moves for reasons that are beyond their control such as their employer transfers them to a different town.

Things can get very tricky when it comes to section 1031, 121 and the personal residence exclusion. It’s always best to speak with a tax 1031 tax professional about your situation to cover all of your bases.

• Start Your Exchange: If you have questions about section 121 and the personal residence exclusion, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Case Study: Paying Down Personal Debt with Sales Proceeds

Recently, we had a client who was looking to do a 1031 exchange on a duplex that they owned. The property was worth roughly $300k, the taxpayer owned $190k and had lived in the upstairs portion of the duplex for 2 of last 5 years. The first question the client had was how to determine the amount of net proceeds he needed to put into the new replacement property?

Half of the Net Proceeds

Assuming that the property is treated as a 50/50 duplex on your prior tax return, half of the net proceeds will go into the 1031 exchange to buy new real estate worth about $150K (maybe a little less due to ½ of transaction costs).

Paying Down Personal Debt

The client also wanted to use the half of the net proceeds that had no capital gains to pay down some personal debt. Here’s the second big question: how much does he need to spend on replacement property to avoid paying taxes on the part that is susceptible to capital gains? Or since the client lived in the property, is the entire thing exempt from capital gains taxes?

Section 121 Exclusion

If you qualify for the Section 121 Exclusion of gain from sale of a principal residence for the portion that you lived in, then you can take half the net proceeds and do whatever you want with that portion.

It’s also important to double-check all of this with your own CPA or accountant.

• Start Your 1031 Exchange: If you have questions about principal residence exclusions and 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved