Mixed-Use 1031 Exchanges
A mixed-use exchange transaction occurs when a taxpayer sells property that includes their “primary personal residence,” and other land, structures, and other improvements used in a trade or business or held as an investment.
Some practical examples are:
- A home office where a business pays the taxpayer rent for office space within the principal residence;
- Farm and ranch land where the taxpayer works the land as their business, but lives in their principal residence also located on the property;
- A duplex where the taxpayer lives in one unit as their principal residence and rents the other unit; and
- A single family home with an accessory dwelling unit (“ADU”), attached or detached, and the taxpayer lives in the home as their principal residence and rents out the ADU.
The list is extensive, but mixed-use exchanges appear when there is a principal residence, commonly referred to as primary residence, on or within the land or building being conveyed as part of one transaction.
As a recap, Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code Section 1031(a)(1) provides: “In general no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” This section of the tax code is a tool to defer gains.
Another provision in the code, Section 121, provides that a taxpayer, “regardless of age, may exclude up to $250,000 ($500,000 for married persons filing jointly) of gain on the sale or exchange of his or her primary residence if, during the five-year period ending on the date of the sale or exchange, the property has been owned by the taxpayer as the taxpayer’s principal residence for periods aggregating two years or more.” Unlike IRC Section 1031, IRC Section 121 excludes capital gain taxes on the sale rather than deferring the tax with no strings attached to how the taxpayer reinvest their sale proceeds.
So, how does a taxpayer take advantage of both sections of the tax code at the same time? First, it’s important to identify your principal residence. A principal residence is not the taxpayer’s second home or vacation home which do not get the Section 121 benefit.
A principal residence is typically a taxpayer’s registered voting address, primary mailing address on your tax return, and other business documents, and the address on your driver’s licenses. As explained above, the principal residence may be part of a business use or investment property.
Here are some frequently asked questions about the interplay between Section 1031 and Section 121:
How is the exclusion amount calculated under IRC Section 121?
Simply consider the original purchase price of the residential portion of the property and the cost of any improvements made to the residence, which is the adjusted basis. Next determine the value of that portion of the property that comprises the residence which is generally a reasonable area that is enjoyed in conjunction with the home. If the taxpayer desires some proof of value, a current market analysis may be obtained from a Realtor® and there are other considerations discussed below. A formal appraisal is another way to substantiate the valuation.
To determine the exclusion amount, the taxpayer will find out if they file their taxes jointly or singly. Single filers can exclude the basis plus an additional $250,000. Joint filers can exclude the basis plus an additional $500,000. The resulting amount is simply cash in the taxpayer’s pocket.
Commonly, taxpayers find themselves with one purchase and sale contract containing both personal residence and 1031 real property with no specific allocation of value to the personal residence. Valuing the residential portion separately is arguably more art than science. The Current Market Analysis mentioned above is one approach. Some value considerations when making the analysis are: (1) the per acre value for a defined small parcel rural residential homesite being greater than per acre value for the much larger farm or ranch acreage; (2) homeowners insurance valuation for the primary residence possibly (3) the current taxable assessed value; and (4) the valuation of other amenities with the homesite that are part of the taxpayer’s enjoyment of the home. This is not an exhaustive list, and taxpayers are encouraged to consult their CPA or tax attorney for additional guidance.
How is the homesite defined in the context of the larger property being sold?
Aerial photos are a great resource in determining the reasonable configuration of the homesite. It’s reasonable to conclude that the principal residence is comprised of not only the house, but well, septic and drain field, landscaping, shelterbelts, ponds, small pastures associated with pets and horses, and any other features that lend to the enjoyment of the residence. Those features can become quite evident from aerial photos.
The resulting analysis of value is a valuable document to be included in the taxpayer’s file as part of the transaction. The taxpayer and their advisors can rely on this resource to not only arrive at the exclusion amount but can reference it from the file if the excluded amount is ever be questioned by the IRS.
Consider this simple hypothetical:
How can the 121 exclusion be used in the context of a property sale with debt payoff?
The 121 exclusion can provide benefits in addition to putting tax free cash in the taxpayer’s pocket. Assume the property sale in the example above required debt payoff to a lender of $500,000. Normally the taxpayer would then be required to exchange equal or up in value replacing $500,000 debt payoff with new debt or inserting new cash into the acquisition of the replacement property.
However, in our example, the taxpayer can allocate the debt payoff to the principal residence. That means the taxpayer doesn’t have to take on new debt or insert new cash into the replacement property acquisition and can retain the remaining $300,000 cash.
How is the 121 exclusion documented at closing?
Documenting the allocation of the sale proceeds partly to the personal residence exclusion and the 1031 exchange is relatively simple. The settlement statement for the relinquished property sale will contain a line item for “cash to exchanger (personal residence)” and a line item for “exchange proceeds to seller” which is the qualified intermediary.
Are there other situations where the 121 exclusion does not apply?
There are situations where the 121 exclusion cannot be used such as sales involving farms, ranches and other business properties which include the owners’ residences, but the entire property is owned by a corporation or partnership. Generally, the IRC Section 121 exclusion is available only to individuals, not S Corporations, C Corporations, or tax partnerships because these entities cannot own a principal residence. That said, business or other entities disregarded for tax purposes (i.e. single- member limited liability companies, sole proprietorships, and grantor trusts) can use the Section 121 exclusion.
In the situations referenced above, it may be possible to distribute the personal residence on the ranch, farm, or other business property out of the entity prior to the sale and exchange. However, it is best to employ some advance planning to assure the distribution takes place at least two years before the sale.
To summarize, the Section 121 exclusion provides taxpayers with tax free cash and no reinvestment requirement. For the personal residence portion of a sale of business use property (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s may also allocate the excluded amount to any debt payoff at sale and eliminate the debt replacement requirements for the 1031 portion of the transaction. There are also opportunities for taxpayers to acquire property in a 1031 exchange, hold the property for five years, live in a residence on the property for two of those five years and claim the Section 121 exclusion on the sale of the residential portion in a subsequent sale transaction.
Note, however, that when participating in a 1031 exchange, the taxpayer’s intent with regard to the replacement property should be that it will be “held for productive use in a trade or business, or for investment” indefinitely. (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s are encouraged to seek the guidance of tax and legal counsel when structuring 1031 exchanges, or when considering changing the character of the investment property.