House Hacking, Section 121 Exclusion, & 1031 Exchange

Buying & Selling Real Estate

House Hacking, Section 121 Exclusion, & 1031 Exchange

Member since 2020 · 2 posts · 0 votes

Hello,

I would like to understand how the section 121 exclusion and 1031 exchange could be applied to a 3 bedroom condo that I own. I lived in the condo as a primary residence for two and a half years, so therefore qualify for the section 121 exclusion until January 2023. Currently, all three bedrooms are being rented out, so the entire unit is now a rental property. However, while I was living there, I was also renting out two of the bedrooms. Based on what I've read online (see https://www.biggerpockets.com/blog/2016-02-21-tax-implications-house-hacking), I can treat the percentage of the unit that I am living in as my personal residence, and the percentage of the unit I am renting out as the rental portion. How exactly is this calculated if there are common spaces such as kitchens, dining rooms, and family rooms? The condo is 1200 sqft total. If my personal bed and bath are 10% of the total sqft of the unit, would I call my personal usage 10% + 10%*[sqft(kitchen,dining,family)/1200sqft], or would it be 10% + 33.3%*[sqft(kitchen,dining,family)/1200sqft] since there were three people living in the condo and I was using one third of the shared space?

How would the capital gains exclusion apply if I sell the condo before Jan 2023? I've read online (see https://www.biggerpockets.com/forums/51/topics/531067-capital-gains-exclusion-with-house-hack) that because this is a SFR, 100% of the gains (up to $250,000 of course) is tax free. However, I have a suspicion this is not actually true based on how taxes are filed with house hacked properties (having to split up the unit into a personal percentage and rental percentage). If the capital gains exclusion applies only to the percentage of the unit designated as personal, can I use the remaining gains from the rental portion for a 1031 exchange?

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
6y
@Spencer Fuller, much will depend on how your accountant treated those bedroom rentals while you lived there. Allocating off portions of a property for investment/primary use is perfectly fine. But the IRS can get very sticky when you're claiming that common portions of your property are being used for investment - much like the home office exemption. It's easy to allocate the second unit of a duplex or a basement apartment with a separate entrance as investment. Your CPA would have created depreciation schedules etc.
If you did not separate these out on your tax return then it's probably not wise that you try to do so at this juncture. Again, your accountant will have a better picture. But I'm just guessing that you'll find it to your advantage (if you can) to simply treat the whole condo as your primary while you lived there. This gives you access to the entire primary residence exemption. So you'll get to take the first $250K of profit ($500K if married) tax free as long as you sell before that 1/2023 date. If your gain exceeds that then you would sell and do a 1031 exchange on the rest of the gain.
That's a much cleaner and conservative way to treat it as long as you haven't already gone the route of creating a depreciation schedule for parts of your house while you lived there.
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Frank Chin
Investor · Bayside, NY · Member since 2017 · 1k+ posts · 1k+ votes
6y
@Spencer Fuller

Agree with @Dave Foster on the above. I ran into similar issues some years back with a triplex I owned and lived in one of the units, rented out the other two. It's best if you have a CPA to get you started on the get go.

With the triplex, I lived in one unit and rented out the two others. So two thirds of the building was allocated to rentals. This two thirds was treated as investment property, depreciated, expenses for the entire building such as property taxes, furnace repairs are allocated two thirds and goes on the Schedule E. Things that are allocated to the owner unit is allocated one third and is deducted where permitted on the personal part of the 1040 such as property taxes.

I never took the home office deduction even through I ran an IT home based business. When the business grew, I first rented a room at a CPA firm, but later took over one of the units in my triplex to run it. Here's where I had to consult my CPA.

The IT business was in an S Corp. I took over the rental unit mid year, so the question is should I keep it rental, continuing to depreciate it, charge the S Corp rent, declare rental income, continue depreciating it, or convert to owner occupied. But it was more space than I needed, some friend looking for office space ask if he can pay me rent, sharing the office, paying half the office expenses such as the phone, internet, and fax machines.

I approached my CPA, and after discussing it, thought it was better to keep it as a rental, not owner occupied, even though I used half the space there. In other words keep things as they are. It was a tenant rental part of the year, I solely used it part of the year, had someone sharing space for another part. He suggested we keep things the same and review things again the following year.

The following year, we decided to keep things the same again. Then the year after, I bought a foreclosure duplex, a much new and nicer property and decided to move there, including my office. A few months later my office mate decided to move his office back home as it was too complicated to find another business to share his space. My CPA and I was glad we didn't change things on the taxes. Now the owner occupied unit was switched to rental, two properties on the schedule E, the original two thirds, with depreciation starting from the beginning, and the one third, originally owner occupied, depreciated separately ten years later when I moved. Interesting the original 2/3 was depreciated at 15 years accelerated, and the other 1/3 was depreciated at 27.5 years, due to changes in the tax laws.

But if we were to record all the changes in the occupancy of the unit used as an office, split the owner part, split out parts of the year, the way the Schedule E is maintained, it would be several properties by itself. The way it was, when I sold the property, I only had two separate items to contend with. And no, couldn't do a 1031 because we couldn't find anything with the time limits.

Sounds like a big long story, But my CPA warned me by not keeping it a rental, that I will make future tax reports a total nightmare during the three years I was using the unit as an office, initially part of the year, then sharing it part of the year, and finally my moving out and office mate had the whole unit for a while.

So keep it simple. Hope you have the condo as owner occupied the whole time, and declaring the rent you collect just as other income. My problem is opposite yours, for me, simpler to treat the unit as rental, for you, simpler as owner occupied.
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