1031 Exchange or 121 Exclusion Out of Duplex?

Question

Hello BP,

I am doing my due diligence and researching to buy a duplex and house hack.

Specifically, it would be a Single Family Home with a detached Granny Flat, purchased with an FHA Loan.

My plan is to live in one of the units, (most likely the granny flat) and rent out the main house, (either long term or airbnb).

My question is when I decide to sell, what are my options and what should I be aware of in regards to 1031 exchange and 121 exclusion options.  I understand I need to occupy the property for 2 years to qualify for 121.  However, can I sell and take advantage of the full 500k tax-free gain (I am married).  Even though I lived in one unit and rented out the main house?

Also, my goal would be to buy another property with the proceeds of the first one.  I have read a 121 and 1031 can be combined and prorated based on the value of the unit rented out versus occupied.  But I'm a little confused on the specifics..

The upleg / 2nd property would most likely be a Fourplex where I occupy 1 unit.  I want to be prepared and educated about my options in advance.

If anyone has experience or can shed light on this issue/situation I would be very grateful!Thank You!

Jonathan Barr · Answer

@Dave Foster thank you for clearing that up.   That makes logical sense but I know sometimes these things don't make logical sense.

Dave Foster · Answer

Logical sense and the government.... not often used in the same sentence!! :)

Dave Foster · Answer

@Jonathan Barr, The reinvestment requirement for the 1031 is going to be at least as much as the allocation to investment on your current property.  If the sale is 1.4 and the two are equal then yes, 700K would be allocated to investment and you could 1031 that.  And 700K would be allocated to your primary residence and you would get the first $250K ($500K if married) of profit on that side tax free.

Split use properties like this resulting from a form of house hacking are awesome for wealth building and getting some cash out tax free.

Alex Olson · Answer

@Jonathan Barr I think it would need to be at least equal to the 1031 amount (net proceeds) maybe more. Bottom line is, though, you need to talk to an intermediary in your area - a real 1032 expert because every situation is different. 1031 is unique to each situation and it is very important that you do it right or you lose the tax benefits.

Jonathan Barr · Answer

sorry just jumping on this thread for similar situation I have.   I am selling a duplex that I lived in 2 out the last 5 years. I am selling it for 1.4 million.   Its in LA crazy I know.   Its two houses on lot which are about equal size.   So the next purchase would need to be atleast 700k which is 50% of the sale price of my relinquished property?

Thanks

Jonathan

Dave Foster · Answer

@Cee Jay, You got it.  You are selling investment real estate for $500K and must replace that with investment real estate for $500K.  If you are planning on living in part of the property you are purchasing then the investment portion (same as the difference between the granny flat and the rental portion) of that building must be worth $500K.

If it was a $600K 6 plex and you were going to occupy one (equal sized unit) you could use your 1031 to buy that property since you are buying at least $500K of investment real estate.

Cee Jay · Answer

@Dave Foster thanks for the reply, that helps clarify things!

A couple questions if you don't mind. I'm a little confused on the specifics in regards to allocating only $300,000 for the 4 plex in your example.  My understanding is that the sales price of the 4 plex needs to meet a minimum requirement, (sales price of downleg) but there is no maximum price?

You said when purchasing the 4 plex, one could only use 1031 proceeds for 75% of the purchase price, since I plan to live in one unit. How does this translate to the downpayment and the capital?

Lets say for example, I buy a SFH with Granny flat for $500,000 originally. After 2 years lets say it's worth $750,000.

Let's say 2/3 of the value was the SFH I rented out and 1/3 the Granny Flat I occupied. In this case, let's assume I'm purchasing a 4 plex for $1,000,000.  I can still use an FHA loan in my county and only need a $35,000 down payment.  Does it matter where the capital comes from for the down payment?

My calculations show the Granny Flat Value went from $166,000 to $250,000... So I can pocket the difference tax free with 121 exclusion.  Next, the SFH went from $333,000 to $500,000..  I can defer taxes on that gain via 1031 if I purchase a property with an investment value of at least $500,000 (subtracting the occupied portion from higher sales prices). Am I missing something?

Thanks in advance!

Dave Foster · Answer

@Cee Jay sec 121 and 1031 can indeed be combined.  In the scenario you are talking about you would get to take up to the $500K of gain tax free (if married) from the allocated % of the property that you used as your primary residence.  The remaining % of the property would be considered the rental and you could 1031 that portion.

When doing a 1031 to buy a  4 plex you will want to remember that you must purchase investment real estate only with the 1031 proceeds.  So if you are buying a 4 plex for $400K and planning on living in one of the units you can only allocate $300K of the purchase price from the 1031 exchange.

1031 Exchange or 121 Exclusion Out of Duplex?

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