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Jul 29, 2010
Sec. 1031 Mixed-Use Property Helps Preserve Layers Of Flesh

Occasionally, the sale of real estate will constitute the combined sale of both primary residence and investment property. The taxpayer may choose to bifurcate the sale of a personal residence on a large acreage into two separate transactions: (i) the sale of a primary residence under Section 121 and (ii) an exchange of investment property.

For example, a house and 80 acres may be worth $1,000,000 total with a $200,000 basis. The taxpayer may exhaust his or capital gains exemption ($250,000 if you are single or $500,000 if you are married) and conduct a 1031 exchange on the balance of property. Divide the sale into two separate transactions, as follows: (i) house and 5 acres, worth $450,000 ($200,000 basis + $250,000 gain exemption under Section 121); and (ii) like-kind exchange of 75 acres, worth $550,000 under Section 1031.

Similarly, you can prorate a townhouse or duplex in urban settings where one level is rented to a third party, and one level is a primary residence. The methodology for segregating these two classes of real property is usually by square footage; however other methods are acceptable under regulations if they can be susbstantiated (like an appraisal).

This method works for both the relinquished and replacement property portion of a 1031 exchange. So tax planners can minimize taxes by combining an exemption and deferral on the front end or maximize a benefit of using tax-deferred money and enjoying personal use on the back end of a 1031.

Many things are possible with careful tax planning. As Mark Twain once said, “What is the difference between a taxidermist and a tax collector? The taxidermist takes only your skin.” Thus, if you want to save your “layers of flesh” collected by the IRS, consult your tax advisors early and not right before you sell property.

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