Sec 121 + 1031 + Sec 121 + 1031 = Say What Now? Can we do this?

[Chris Lynn]

Four years ago we got lucky and were able to buy the 2-unit building we'd rented in for the previous 18 years. One unit was vacant and we fixed it up with the intent to AirBnB it. Just as it was finished, my mom was forced out of her apartment so we agreed to rent our vacant unit to her. That was almost two years ago. Now we want to sell and we'd previously looked into our ability to Sec 121 based on our unit having been our primary residence and also utilize a 1031 with the proceeds from the rental portion of the sale. That was several months ago, some things changed for us and we had to pause everything but now were getting back to exploring our selling options. Well, when we realized my mom had been here almost two years we started wondering if we can add her to our title thereby making her eligible to claim an additional $250k Sec 121 Cap Gains exemption on the sale's proceeds. If so, we're wondering if we'd still be able to put any remaining proceeds into a 1031 purchase based on her two years as a tenant. 

If anyone can give us some guidance here, we'd love to get some clarity. Thanks so much! 

[Frank Chin]

Seems like you had the place for 4 years already. How did you file your income taxes.

In our case, we had lived in MR's and when filing taxes, include the tenant unit as a rental, depreciate that portion, and deduct those as rental expenses on the schedule E. Then on sale, the owner portion and rental portion is handled separately, paying cap gains for the rental portion only. 

So if you were to add your mom to the deed now, you cannot mask the fact it was treated as a rental if you filed taxes as I described. If you handled thing informally with your mom, not including her rent on your taxes, stop depreciating it the last two years, then both portions would be sec. 121 in the eyes of the IRS, though you may have some recapture of depreciation for the rental portion for the 1st 2 years. In the latter case, you need not include her on your deed, as might lead to estate planning issues later on.