Split 121 tax exclusion and 1031 question

[Channing Huntington]

I am in a situation that seems well-suited for a home sale with capital gains that are split between the section 121 primary home capital gains tax exclusion and a 1031 exchange for rental property:

Spouse and I have been renting 30% of our primary home for some time. Two years ago we relocated for work purchased a new home, and began renting the remaining 70%. So, if we sell within the next 12 months, I believe we fall within the "2 of the last 5 years" condition of the primary home exclusion, but only for the 70% that we were previously living in. We'll owe capital gains on the other 30%, as well as on any amount over the $500k exclusion limit.

The numbers are roughly the following:

Purchase price: $500k

Improvements: $100k

Depreciation taken over the course of renting: $70k

Adjusted basis: $530k

Est. Sale price $1.2M

Costs (6% of sale): $72k

Capital gain: ~$600k (This is $1200k - $530k - $72k)

Per section 121, we would take 70% of the first $500k tax free = $350k

The remaining ~$250k would be subject to 15% federal and 13.3% California tax = $88k.

There is also the issue of depreciation reclamation at 20% = $14k (not sure how this is accounted for).

SO, we could pay the tax and net another $160k, or roll the $250k into a 1031 exchange.

My questions for the 1031 experts:

What happens with the mortgage balance? Assume for round numbers that it is $300k at the time of sale. Is it the case that I *must* borrow $300k * .3 = $90k towards the replacement?

What would happen with the depreciation recapture? Would 30% of it be deferred, or all of it, or none?

I am not primarily a landlord and it's not clear to me that I want to bother with a 1031 (heresy here, I know!) for $90k, but I *do* want to make sure I understand the numbers.  Thanks for the help.  

[Dave Foster]

@Channing Huntington,  You may not need the 1031.  If you have simply been renting some of the shared living space then I believe you do not have to separate out the prorations for a sale under 121.  But that being said you also must have declared the rent.  And if you've actually carved that out and depreciated it then that is a different matter and you'll want to get your accountants okey dokey confirmation.  

But if that is so then you can sell before the 5 years is up and take the first $500K of profit tax free.  And you would only do your 1031 on the remaining 100K of gain and depreciation recapture.  The mechanism is that you sell the property and start a 1031 exchange.  At the start of the exchange you take $500K in boot.  Normally this would be taxable but since you qualify for 121 you get to take it tax free.  That would leave you with a 1031 in which your responsibility was to purchase $700K of real estate using the rest of the proceeds.

If you weren't depreciating before you moved out entirely then your depreciation recapture would be minimal.  But if you do a 1031 exchange on the 30% then your depreciation is deferred as well as the capital gain. 

There's really no bad scenario for you here.  But much hinges on how your accountant has treated it over the years.