Subdivide a property to get a 1031 exchange

[Assaf Furman]

Here's a scenario I came across:

Say I own a house which I'd like to to sell and buy another one which I'll live in. Now say I've found a property with two houses on it, and it's subdividable so that each house will sit on it's own lot and I can call one of them an investment property. 

Can I buy that property, subdivide it, and then exchange the sell of my house towards the purchase of the investment property?

[Dave Foster]

@Justin Hewett, sorry to be the bearer of bad tidings but the scenario that @Assaf Furman described actually would not be an appropriate 1031 exchange.  Hopefully he found that out before attempting it a few years ago.

There is a way to accomplish what you're wanting to do but it's a little more complicated than buying the property and then subdividing it and 1031ing into the part of the property you are keeping.

The problem is that you cannot take title to your replacement property before you close the sale of the old property.  Asaf wanted to buy the new property and then subdivide it and then sell his old property and 1031 into the half he wants to keep.  He cant do that because he would be taking title to his replacement property before he sells his old property.

The two ways to accomplish this would be:

1. To sell your old property and buy the new property in it's entirety.  That would probably satisfy the concern that Bill rightfully had about making sure the valuations work the right way.  It would also allow you to sell first and then purchase which the statute requires. 

The down side to this scenario is that your gain will be spread over the entire property.  So if you subdivided and then sold half you would pay half of the gain from your exchange.  It couldn't all go into the new property.

2. Option 2 would be to do a twist on what is called a reverse exchange.  In a reverse exchange the QI takes title to the replacement property and holds it for you while you subdivide and improve the property.  It would be possible to deliver that property to you with the QI completing the exchange for 50% of the property and you take title to the other 50% outside the exchange.  

This scenario lets you put all the gain from the 1031 into the half you'll keep.  and you would only pay tax on whatever profit was generated by the subdivide.  downside is that the reverse exchange is a much more expensive and complicated process.