1031 Exchange with mortgage

[Nancy Chawla]

We have a two family home. We live on one floor and the other half is rented. The property is being sold for $1 million with a mortgage of about $300k. We're planning on doing a 1031/121 combo. The rental half is essentially half the property, so worth $500k. I need help understanding how the mortgage will be handled. If rental portion is half, then mortgage would be $150k. 

1. Would that $150k come out of the $500k proceeds involved in the exchange?  
2. If the answer to the above question is yes, then I'd have $350k to use in the exchange. So if I buy a replacement property worth $500k, can I use proceeds from the personal residence half to cover the other $150k? Or would that result in a taxable event because my mortgage would go from 150k to 0? 

[Sean Ross]

Hello @Nancy Chawla,

You will still need a 1031 exchange for the half of the home that has not been treated as your primary residence.  It doesn't matter whether you qualify for Section 121 treatment on the other half, which I hope that you do. The tax exemption for Section 121 will not apply to the investment/rental portion. 

Here's how the 1031 rules break down for the rented-out $500K portion of your two-family home:

1. Unless you specifically took out a mortgage that is only applicable to the primary residence portion of the home, then the mortgage will be split pro rata between the two halves (so $150K each, in this case). 

2. When you sell, the $150K will be paid off at closing, only leaving $350K to be used in the exchange (I am ignoring closing costs in this breakdown). 

3. If you don't want to take out debt on the 1031 replacement property, then you can supplement $150K from the proceeds of the personal residence half -- or from any other source that you like. This way you can bring $500K of total down payment on the new property. 

Technical point: While you will technically incur "mortgage boot" by not replacing the debt in your new property, using another cash source to replace your debt gives you a "boot offset"; meaning you won't incur tax on the mortgage boot by doing this. 

Now, 1031/121 splits are common.  But, they're fraught with little nuances that depend on your circumstances. If you are not already working with a Qualified Intermediary on this, I'd be happy to give you a free consult to walk you through the details of your case.  If you are already using one, I'd be happy to act as a second opinion for you.