There are only a few ways to receive special tax treatment on the sale of real estate. One is IRC Section 121 (“primary residence” exemption), for those who qualify and another is IRC Section 1031 tax deferral on the exchange of investment property that qualifies under Section 1031 and the Treasury Regulation guidelines.
But what if a taxpayer lives in one of the units of their multi-family property; or a farmer who lives in a modest house on a larger working farm; the owner of a hotel who resides on the top floor; or a pizza shop owner who lives in the unit above their shop? These are not uncommon situations in Massachusetts and the neighboring New England states. Before we jump into the intersection where both IRC Section 121 (primary residence) and IRC Section 1031 (investment or business property) meet, let’s take a look at the highlights for each of these two tax code provisions
Highlights of Section 121 Principal Residence Property (taxpayer lives in the property):
• Tax exclusion;
• The taxpayer must use the property as a principal residence for two out of the last five years prior to the sale;
• The use as a principal residence does not need to be in concurrent months;
• Exclusion of $250,000 of gain for single filers and $500 ,000 of gain for married taxpayers filing jointly;
• The §121 exclusion is only available once every two years; and
• Second homes and vacation hones do not qualify for §121 tax exclusion.
Highlights of a §1031 Exchange Property (taxpayer uses property for trade or business or the property is held for investment):
• Tax deferral;
• The taxpayer must hold both the relinquished and the replacement property for use in a trade, business or the property must be held for investment (called “like-kind” property);
• The taxpayer cannot receive the cash proceeds from the sale and must engage a qualified intermediary (QI) prior to the closing to structure a valid §1031 exchange;
•There are strict rules for deferral including 45/180 day time deadlines in the delayed exchange format along with other requirements such as reinvesting the entire net equity and having the same or greater amount of debt to obtain full tax deferral.
So, in a situation where the taxpayer resides in a “mixed use” property which is part primary residence and part business or investment property, the taxpayer can take advantage of both tax codes respectively upon the sale in a “split treatment” transaction. Here are two examples:
Example #1: The sale of a four-unit property (fourplex)–part residence; part rental property: The taxpayer owns a 4-unit multifamily property in which they have rented three units (§1031) for the past four years and where they have also lived in the remaining unit as their principal residence (§121) for the past four years (meeting the requirement under §121 to have used as a principal residence for at least two of the past five years). The property is sold to a buyer and the taxpayer receives a portion of the sale attributed to the principal residence portion (§121) and obtains tax exclusion up the Section 121 threshold amount and has a QI engaged to prepare the necessary §1031 exchange documents and hold the net proceeds from the sale of the three rental units to proceed with a §1031 exchange into like-kind replacement property, thus obtaining tax deferral on the three rental units.
•A split treatment transaction involves a property used partially as a principal residence and partially in a business or investment purposes;
•The taxpayer must work with their tax advisor to allocate the portion used as a principal residence for tax exclusion under §121 and the remaining portion qualifying for §1031 exchange deferral;
• The taxpayer can receive the sale proceeds directly from the closing on the principal residence allocation of the transaction;
• The taxpayer must have a QI in place for the §1031 exchange portion of the transaction (i.e. the portion allocated to business or investment.) The QI will receive the portion of the sale proceeds for the business or investment portion and the QI will acquire like-kind replacement property pursuant to the §1031 exchange rules and requirements. The taxpayer must meet all other requirements necessary for a §1031 exchange.
Example #2: The sale of a 100-acre farm/ranch with the allocation of a primary residence on 5 acres: The taxpayer has owned a 100-acre working farm for the past four years and has lived in the farm house on the property. The minimum amount of acres for a primary residence allowed by the county in which he resides is five acres. The property is sold to a buyer and the taxpayer receives the portion of the sale attributed to the principal residence portion, principal residence and five acres of land (§121) and has a QI engaged to hold the net proceeds from the sale of the farm land portion 95 acres, with a §1031 like-kind replacement property.
• This is an example of a split treatment transaction involving a property used partially as a principal residence and partially for a farm;
• The taxpayer and their tax advisor must allocate the portion used as a principal residence for tax exclusion under §121 and the remaining farm land portion qualifying for a §1031 deferral;
The taxpayer can receive the sale proceeds directly from the closing on the principal residence allocation of the transaction;
The taxpayer must have QI in place for the §1031 exchange portion for the transaction (i.e. the portion allocated to ranch land). The QI will receive the portion of the sale proceeds from the farm land portion and the QI will acquire like-kind replacement property pursuant to the §1031 exchange rules and requirements. The taxpayer must meet all of the other requirements necessary for a §1031 exchange.
Farm and ranch transactions can often include both personal and real property. The taxpayer’s tax advisor should review the allocations to make certain real property is exchanged for like-kind real property and, in the event of a farm/ranch transaction involving significant personal property that the personal property allocations are reviewed on both the sale and purchase sides of the transaction.
Note: Asset Preservation, Inc. as a qualified intermediary does not provide tax or legal advice. Taxpayers should seek advice from their own tax and legal counsel regarding their specific situations.
Lynne Bagby, CES is the Northeast division manager for Asset Preservation, Inc., Boston, Mass.