Primary Residence exemption and/or 1031 Exchange

Tax, SDIRAs & Cost Segregation
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Primary Residence exemption and/or 1031 Exchange

Fausto CarosellaPro Member
Real Estate Broker · Boca Raton, FL · Member since 2014 · 98 posts · 23 votes

Hey All,

My parents are going to sell their primary residence they've lived in since 1984 in a suburb of Boston. It's a triplex. For the sake of simplicity I'm going to round the numbers. They bought it for 100,000 and lets say they sell it for 700,000. As a side note they already purchased the home here in Florida they will be moving into with cash and have been renting that out for a couple years. My question(s) is what amount will they pay capital gains taxes on? Will the 600,000 gain be divided by 3 and they won't pay capital gains on only their particular unit, or will the 500,000 max exemption apply to the whole building? If they wanted to work a 1031 exchange into this process how would that apply? Would they be able to 1031 the two rental units avoiding capital gains there and also use their primary residence exemption to avoid capital gains on their particular unit? I believe they can vacate the unit and then rent it out for a certain period of time (how long I don't know??) and then 1031 exchange the whole building... is that correct? What's the best way to go, and has anyone done any of these options? Thanks ahead of time!

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  • Bill ExeterBusiness Member
    1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
    9y

    It is a triplex, so the taxable gain will be allocated between the three units.  Your parents would be able to take the 121 Exclusion (tax-free exclusion) on their specific unit. 

    The other two units would qualify for 1031 Exchange treatment.  The 1031 Exchange would be set-up for effectively 2/3 of the property, assuming that the three units are all the same size. 

    Yes, they could move out of the one unit, rent for a period of time (long enough to demonstrate that they did in fact intend to convert to and hold as rental property), and then sell and they would qualify for the 1031 Exchange on the entire property.  I would recommend renting for 24 months to be safe (just my opinion) and then sell and close before the end of the three (3) year window after they move out. 

    However, the tax-free exclusion is enticing, so I would really look at selling, taking the 121 exclusion on their unit, and then exchanging the balance.  It is hard to pass up tax-free gain. 

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    9y

    @Fausto Carosella, They can take all of the gain allocated to the % that they have lived in tax free up to the $500K limit and can 1031 the remainder % so they avoid all tax.  When you mention the idea of them moving out to FL and then renting their former residence part for a bit to qualify for 1031 it raises an intriguing possibility.

    1. Tax free is almost always better than tax deferred so it's difficult for me to discern a reason to throw all of into a 1031 which is only tax deferred.

    2. But that being said, if they are flexible and want to hold onto the property for a bit they could certainly relocate to FL and turn that 1/3 into a rental as well.  As long as they sell the property within the next three years they'll still get to take the primary residence tax free allocation (watch the calendar closely so they can verify residence 2 out of the 5 years prior to sale). They will have to recapture depreciation during that time but gain will still be tax free.  

    This would allow them a more measured transition and let them capture 3 more years of appreciation and cash flow while still garnering tax free treatment on the residence portion.

    If they go over that  5 year look back for some reason then the entire property would be eligible for 1031 treatment.

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  • Fausto CarosellaPro Member
    OP
    Real Estate Broker · Boca Raton, FL · Member since 2014 · 98 posts · 23 votes
    9y

    @Bill Exeter and @Dave Foster Thanks for your responses. The unit they reside in is identical to the one directly above it. The third floor is a smaller unit. Who and how in this process would discern the value for each unit? Using the above example of selling for 700k, let's say the bottom two identical units are determined to be 300k each, while the third floor is determined to be 100k. As I understand it they would be able to take the 400k from the top two units and use those funds in a 1031 exchange, there will be no recapture of depreciation since they are rolling those funds into another investment? The unit they live in will be well under the 500k limit for the 121 tax exclusion... so again using the above numbers (and roughly rounding) if the purchase price was 100k, broken down the units would be something like 45k, 45k and 10k... basically they paid 45k for their unit. They are selling it for 300k leaving them with 255,000 profit.... That 255,000 will be tax free? How will recapturing depreciation factor into that 255,000? Thanks again guys! very much appreciated!

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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    9y

    @Fausto Carosella, Yep that's roughly it.  Their accountant has probably already made those allocations when putting the two units into service.  The only way depreciation enters at all into the primary residence portion is if they rent it out for a while before selling.  Right now my understanding is that the unit they live in has never been rented.  So there has been no depreciation claimed against that portion.

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  • Fausto CarosellaPro Member
    OP
    Real Estate Broker · Boca Raton, FL · Member since 2014 · 98 posts · 23 votes
    9y

    @Dave Foster That's correct, the unit they occupy has never been rented out... so to recap: upon selling they will defer their taxes on the top two units with a 1031 exchange, not have to pay taxes on their own unit with the 121 tax exclusion, and since that unit is their own home they will not have the depreciation recapture because it was never used on that unit. (assuming they filed that way properly up to this point).... that sounds like a pretty good scenario!

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