Over the last couple of years, I have written a number of articles in this blog about tax-deferred exchanges of investment property under Section 1031 of the Internal Revenue Code (“IRC”). If owners of commercial real estate comply strictly with the mandates of this provision in selling their property, they can successfully defer the recognition of gain (and resultant taxes) until they dispose of the assets they acquire with the proceeds.
Section 121 exclusion
In a prior blog post, I explained how real estate investors may be able to combine the benefits of both the IRC Section 1031 deferral of gain and the IRC Section 121 exclusion of $250,000 of gain on the sale of a personal residence, by exchanging their commercial property for residential rental property that is later converted into a personal residence, and is then sold. Another situation in which a property owner can claim the advantage of both of these tax policies occurs when real estate is held for both personal residence purposes and business purposes.
Real estate that has both commercial and residential aspects, which is generally included under the broad rubric of mixed-use property, may be found to exist under a variety of different situations. Some common instances of mixed-use property are:
- Multi-unit residential properties where the owner lives in one unit but rents out the rest;
- Agricultural land on which a home has been built; and
- Home offices.
Possible to dispose of your mixed-use property
Most of you are probably acquainted with a professional service provider, such as an attorney or a psychologist, who chooses to perform services and meet clients in a room or specific portion of his or her house. This “home office” establishes a business use within that residence, and you are likely familiar with the income tax deductions that such use can generate. What you may not know is that, as this residential real estate is thus at least partially held for investment, the “home office” portion may qualify for tax-deferred treatment in an exchange for other investment property, while the residential portion may qualify for exclusion of gain of up to $250,000 ($500,000 if married filing jointly) under the Section 121 exclusion from gain if the dwelling has been the taxpayer’s primary residence for two of the last five years. Thus, by using both Section 121 and 1031, it may be possible to dispose of your mixed-use property without having an immediate taxable event.
In following this strategy, caution must prevail: The path to success lies in careful attention to the details. The method of valuation of the property, the allocation of value between uses, the length of time in the residence, the amount of time used as a business asset, and even the specific way in which the escrow closing statement accounts for rent or other such credits can affect how an exchange is treated. Highly-qualified legal, tax and exchange professionals are well worth the cost in facing these situations.
The Internal Revenue Service has issued a publication (Internal Revenue Bulletin 2005-7) that provides detailed and valuable guidance and examples on how these two IRC sections can be combined for maximum tax deferral and savings under the law, which can be found here.