Landlord Lives in Part of A Duplex That Is Rented.
Question
I recently purchased a duplex in LA. It is my first purchase of rental real estate. I live in the top unit and rent out the lower. The units have two separate street addresses. I understand the basics of the 1031 exchange, but since this property is my home, is it still under the guidelines as “investment property” when I go to sell? Do I have to live here for a set amount of time to change the situation, or does that matter? Will a 1031 exchange be required to avoid taxes? What if I want to buy a single-family home for myself to live in as my primary residence?
Answer
First, as you would expect, when trying to minimize income taxes, there is a difference between income property and a personal residence. In the limitations of this format, I will only speak in abbreviated general terms, so you should (1) read relevant discussions regarding Section 1031 provided by various LandlordOnline.com resources, (2) consult a CPA or other tax advisor, (3) read some books, and/or (4) read the relevant IRS publications regarding the details of your particular situation.
During the period when you use one of the units as your personal residence you will treat your duplex as part personal residence and part investment property regarding its purchase and if you still reside there at the time of sale you will do the same. Terminating your residence during the period of ownership will require changes regarding tax issues. The fact that there are two different street addresses should not matter.
If the units are essentially identical, it will probably be half-and-half. Otherwise the allocation will be based on some material fact(s) such as the relative sizes of the units. This means that all expenses of the rental half are deductible, whereas, only interest and property taxes are deductible (if you itemize) for the personal half. Costs of depreciable items (for example a new roof) would be depreciated for the rental half, whereas, those costs would be added to basis for the personal half.
Section 1031 of the IRS code provides that 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 a business or for investment. The definition of like kind property is very broad. One can exchange an apartment building for a retail center or either of those for a piece of land. One can even exchange a rental property for a timber lease. There are a number of possible types of exchanges and some potential pitfalls, but the basic restriction regarding a 1031 exchange is that the seller cannot have constructive receipt of funds. One should usually involve competent and experienced professionals when doing an exchange.
Section 121 of the IRS code allows a taxpayer to avoid taxation of gain on the sale or exchange of a property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more. The amount of gain that can be avoided is $250,000 for a single taxpayer and $500,000 for a married couple filing jointly.
The gain from properties that have more than one use can usually be divided between Section 121 and Section 1031 so as to realize the benefit of the applicable law for each part. Accordingly, if you meet the requirements of both Code sections, you should be able to exchange the rented unit of your duplex into another rental using Section 1031 and avoid taxation on the unit you occupy under Section 121.
Both Section 1031 and Section 121 will likely change significantly if Congress ever undertakes a major revision of the IRS Code.