Many investors sell investment property that includes their personal residence. We see this in many farm operations where the house is located on the farm. Also, many city dwellers recently converted their personal residence into a combination of rental property and their home.
You cannot exchange a personal residence under Section 1031 into investment property. Rather, the sale of a personal residence is handled by Section 121. This allows a married couple to have up to $500,000 of tax-free gain. Only gain that exceeds that amount will be subject to long-term capital gains (currently a maximum rate of 23.8%). Single taxpayers can exempt up to half this amount.
To meet this requirement, you must have lived and owned the residence for at least two of the preceding five years before the date of sale. Also, if you did not continuously live in the home since 2009 (or from the date of purchase), some of the gain will be taxed even if you are under the Section 121 threshold.
Finally, if you use part of the home as a home office for income tax purposes, you will be required to recapture any depreciation taken and part of the home sale may be fully taxed unless you do a 1031 exchange on that portion.
A sale of home that is part personal residence and part rental/farm/commercial requires us to bifurcate (one of CPA’s favorite words) the transaction into two or more parts. The value allocated to the home is split away from the exchange value. This “sales price” will be reduced by allocated closing costs to arrive at a net sales price. This net sales price less allocated (or direct) liabilities related to that portion is paid to the seller. It will not be part of the exchange.
The remaining allocations and net proceeds will flow into the exchange account and be available to roll over into investment property.
Let’s look at an example:
Bill and Mary have farmed all their career and are in the process of selling the homestead for $2.5 million. It includes 160 acres with a home, shop, a grain facility with the rest in cropland. About 10 years ago, Bill and Mary built a very nice new home on the acreage and based on discussions with their realtor determined that fair market value for the home and a few acres associated with the home that has a pond on it is worth $750,000 (net cost of $400,000). The property was originally free and clear, however, they incurred a mortgage when building the home and the current balance is $175,000. The sale will incur $200,000 of selling costs. The home allocation is $750,000 minus $60,000 of selling costs minus $175,000 mortgage or $515,000 of cash. This amount is paid to Bill and Mary at closing. The remaining $1,610,000 is placed into the exchange account with the qualified intermediary (QI).
Now let’s change the facts and assume the mortgage is not directly tied to the home. In that case, the sellers will receive an extra $122,500 of cash since 70% of the mortgage would be allocated to the farm.
Planning opportunity
Since up to $250/500,000 of gain from the sale of a personal residence can be tax-free, allocating the proper amount of fair market value to the home is critical. The goal is to increase this FMV to maximize the tax-free gain, however, you must make sure to have proper documentation from a qualified realtor/appraiser.
Section 1031 into a personal residence
Some investors would like to sell investment property and then purchase property that will become their personal residence. The quick answer is that you can’t do this. However, if you purchase property that is rented out for a sufficient amount of time and then decide to live in it, a 1031 exchange may work.
The definition of sufficient time is not in the tax law. It is generally understood that renting the property for at least two full years is sufficient. Other commentators suggest even a longer period of time.
My suggestion is to rent it for at least three tax years before moving into the house. Tax years are not necessarily twelve full months but rather any month in a calendar plus full calendar years. For example, if you purchase the property on December 1, 2020 and rent it until January 15, 2023, you actually have four tax years (2020, 2021, 2022 and 2023).
Conclusion
The sale of a personal residence with investment or commercial property can be done. You just need to make sure to dot your I’s and cross your T’s. A reduction in capital gains taxes will be the happy result.
Paul G. Neiffer, CPA, Principal, Agribusiness, CLA (CliftonLarsonAllen LLP) can be reached at
509-823-2920 or paul.neiffer@CLAconnect.com.
