Partial 1031 Exchange?

[Erin Madden]

I have what I think is a fairly unique situation, but I'm hoping someone on the list may have experience with similar...I live in a house that I purchased in 2010. From 2010-2016, it was a rental property. It became my primary residence in 2016. In 2018, we put an Accessory Dwelling Unit in the basement that has been rented long term since January 2019. 

We are considering selling the property and trying to figure out whether a 1031 exchange is needed and if so, possible given that it is currently our primary residence (but also partially an investment property thanks to the ADU).

Regarding the fact that it was a rental for the first 6 years we owned it (and we have owned it about 12 years), I believe that about half the gain from the sale will be subject to capital gains tax. (I understand there will be depreciation recapture tax also). But what effect does the ADU (rented since 2019 while the house has been our primary residence) have on this calculation? And if we need to do a partial 1031 exchange to defer the capital gains taxes on the non-excludable portion of gain, can we do that since it is currently our primary residence? Are we limited in some way to in the amount we can exchange based on some proration of square footage (or otherwise) for the ADU vs the primary home?

I have tee'd up the basic question with my accountant, but given that she's in the middle of tax season craziness and we are considering options right now, I thought I'd post here to see if anyone might have some insight they can share. Thanks in advance for any help you can provide!

[Dave Foster]

@Erin Madden, Your tax return will tell the numbers. But, if that ADU/basement has been separated as investment on your tax return. Or if it is a separate unit then you will need to 1031 that to get tax deferral.

The portion you live in will qualify for the primary residence exemption.  But because that property started out as a rental you'll only get to pro rate the gain between the years you live in it and the years it was rented.  And you'll have to recapture depreciation.

Your best move to get maximum tax relief would be to Take the partial exemption for your residence portion. And do a 1031 on the basement portion.  This will leave you with a smaller tax bill, some gain tax free, and the rest tax deferred.