When it comes to 1031 exchanges, many investors worry about the strict rules surrounding these transactions and that any misstep or deviation from the norm could disqualify them from tax-deferred treatment. One of the most basic rules we’ve discussed when it comes to 1031 exchanges is that the property must be used for investment (or used in business or in a trade). But this doesn’t mean that the property must have always been used solely for investment or business purposes.
“Mixed-use” property—property that is used for both personal and investment purposes—may also be eligible for 1031 treatment in certain cases. In order to benefit from tax-deferred treatment when you use mixed-use property in a 1031 exchange, you have to invoke a different section of the Internal Revenue Code, section 121. Invoking section 121 enables you to take advantage of a separate tax deferral mechanism so that the gain derived from the personal use part of your property does not trigger tax liability.
Let’s discuss the details below.
Section 121 Allows Taxpayers to Exclude Gain from the Disposal of a Principal Residence
Section 121 of the Internal Revenue Code is designed to enable taxpayers to defer gain derived from the sale or exchange of a primary residence (as defined by the code). This section is often referred to as the “principal residence exclusion.” Under this section, you may exclude up to $250,000 ($500,000 for married couples filing jointly) of gain. Section 121 does not apply to investment or business property, and in this way, it mirrors the applicability standards of section 1031. As we know, section 1031 applies specifically to investment or business property and does not encompass property used for residential purposes.
Upon first glance, these two sections would appear to have little to no connection with each other, as they apply to different types of property and expressly limit their applicability to one particular type of property. But they may be joined together when a mixed-use property is used during a 1031 exchange.
Suppose, for instance, that you use a piece of property as your primary residence for four straight years. Then, for the next two years, you convert the property into a rental property. Under current law, this taxpayer may transfer this property as part of a 1031 exchange and use the principal residence exclusion to exclude the gain which would otherwise normally create a tax liability. You might think that such a property would be disqualified from either section because of its mixed-use status, but the IRS has taken the position that the property can benefit from both sections. Revenue Procedure 2005-14 neatly lays out the views of the IRS on mixed-use transactions.
Revenue Procedure 2005-14 Provides Guidance for Combining Sections 121 and 1031
Revenue Procedure 2005-14 makes it clear: Any gain excluded under section 121 in a 1031 exchange transaction is treated as gain recognized by the taxpayer, and so your basis will be increased by the amount excluded under section 121. Basis computation in mixed-use 1031 exchange transactions can be a bit tricky at times—especially when you attempt to exchange a property which has a certain percentage devoted to a business purpose—but this is a small price to pay for the ability to defer all of your gain.
Even though the IRS has provided instructions for the entire public to follow, it is still imperative that you obtain capable assistance whenever you attempt to go through with a 1031 exchange involving mixed-use property. As mentioned, if you go solo, you will likely encounter difficulties when you compute your new basis, and the last thing any investor wants is ambiguity in this area. CWS Capital Partners has experience with mixed-use 1031 exchange transactions and has the ability to assist you with this matter.
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