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1031 Exchange : Buy 3 Get 2 Rented

Real Estate Blog : Investment Property : Los Angeles : Manhattan Beach : Hermosa Beach : Redondo Beach : Palos Verdes : Torrance

Real Estate Blog : Residential Commercial Income Investment Property

1031 Exchange : Buy 3 Get 2 Rented - Living in 1 Unit, Renting out 2 Units

Internal Revenue Code Section 1031 exchanges allow real estate investors to defer capital gains taxes by exchanging their investment property for like-kind investment property. Internal Revenue Code Section 121 allows taxpayers a capital gain exemption on owner occupied property provided the property is the taxpayer’s primary residence and the owner has lived in the property for at least two out of the past 5 years.

What constitutes an investment property and what constitutes a personal residence becomes an important issue when a taxpayer owns multiple units at the same address. One such example is a triplex when the owner lives in one of the units as a personal residence and rents out the other units for investment.

Let’s examine a case study in which a recent client sold a triplex and was able to use the Homeowners exemption and the 1031 Exchange together on the sale.

Facts:

  • A married taxpayer filing jointly owns a triplex.
  • Two of the units are 1,200 square feet and have been rented out for 5 years.
  • The taxpayer lives in the third unit, which is 1,500 square feet.
  • The taxpayer is contemplating selling the property for $1,000,000, which would generate a realized gain of $300,000.

Analysis:

Given the facts of this example, it appears as though the property qualifies as a partial personal residence and a partial qualifying 1031 Exchange property. Assuming this is true, how would the taxpayer allocate the sales price and gain between the investment and personal residence portions of the property? Authority on the issue requires the taxpayer to use the same method for allocating tax basis and amount realized on the sale. In addition, the taxpayer is required to use the same allocation method used when determining the depreciation deductions on the investment portion of the property.

In our case, let’s assume the taxpayer allocated for depreciation using the percentage of square footage the investment represented in proportion to the total square footage of the property. The investment portion of the property represents 2,400 square feet. The total square footage of the property is 3,900 square feet. Therefore the investment represents approximately 62% of the total square footage. The taxpayer uses the same method for determining the allocated sales price and gain on the sale. In our case, $620,000 of the sales price will be allocated to the investment (1,000,000 x 62%). The remainder of the sales price, $380,000, will be allocated to the personal residence unit. The amount of the gain is similarly allocated after taking into account depreciation recapture.

Assume that the taxpayer had taken 100,000 in depreciation on the investment over the 5 years of ownership. The $200,000 in gain not attributable to depreciation would be allocated 62% to the investment and 38% to the residence. The end result would be $224,000 allocated to the investment ($100,000 + $124,000) and the remaining $76,000 to the residence.

If the taxpayer has not taken depreciation on the investment portion of the property, they may allocate between the units in any reasonable manner. The most common methods of allocation include by unit, by square footage, by the quality of the interior improvements or by appraisal. For purposes of determining the adjusted basis of the investment, the taxpayer must impute depreciation and reduce the investment tax basis as if they had taken the deduction.

After the taxpayer determines how much of the sales price is allocable to the personal residence and the investment, they may use Section 121 and 1031 together to avoid paying taxes on their capital gains. Section 121 is a tax exemption so the capital gain is eliminated up to the maximum of $500,000 in our example. Section 1031 allows investors to defer paying tax on their capital gains provided certain requirements are met.

Shared By Leonard, Your 1031 Guy

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