Hey, so I have a few thoughts on this that may or may not be helpful (depending on whether you truly end up facing a capital gains tax bill, etc.). I wound up typing a lot, so at the risk of being overly formal, I made a table of contents.
- Watch Out for Tax Reform!
- Safe harbor(s) for 1031
- Partial or Split 1031/121?
- Idea for meeting 1031 45 Day Deadline
- Ownership and Use Req. for 121
1. Watch Out for Tax Reform!
The 1031 exchange (and the ability to deduct the interest on your investment real estate loans) may eliminated soon. I would encourage you to think about the implications of not having the 1031 as a tool in your tool chest a year from now. Probably wise to acquire something that you can afford to hold long-term [EDIT: I just realized that the Deferred Sales Trust I brought up in another comment elsewhere might become a popular option if it survives tax reform and the 1031 doesn't.] I'm not sure what to say about how one might wisely anticipate not being able to deduct business/investment interest. Just figure that change is coming. If you have ideas, let me know.
2. Safe Harbors for 1031
So in a 1031 both the relinquished property and the replacement property have to be held with the intent to be predominantly used for business/investment purposes. That means there are two sets of “safe harbor” guidelines, according to which the IRS will not challenge whether a property is held with predominant business/investment intent: one set of guidelines for the property to be relinquished and another set for the property to be acquired. They happen to be very similar.
Note that the actual requirement has only to do with the intent to hold a property predominantly for business/investment purposes. Rev. Proc. 2008-16 specifies “safe harbor” conditions under which the IRS will not challenge one’s intent to hold a replacement property for business or investment purposes. IRC § 1031 even addresses properties held for fewer than two years (only the periods during which the property was held are taken into account, unless it looks as though an individual is deliberately trying to “avoid the purpose” behind the code).
The safe harbor, essentially, is something like that IF…
1.…a property is held for two years or more, AND
2.during each of the two years before or after the exchange it is rented out for 14 days or more, AND
3.during each of the two years before or after the exchange it is not used for personal purposes for any more than 14 days OR 10% of the duration for which it is rented out…
…THEN its intent to be held for predominantly business/investment purposes will not be challenged by the IRS.
3. Partial or Split 1031/121
On this I am less familiar, but I am quite sure one can perform a partial 1031, giving the 1031 treatment to the investment portion of your equity, and I am pretty sure this goes for the 121 home sale exclusion as well, so that *I think* an option might theoretically be to do a 1031 with the investment side of the duplex and a 121 with the side you're living in. It's not clear whether this would be possible or whether it would be applicable for your exact needs here, but it's worth mentioning. Would love to have this corrected or clarified by someone else on here (probably a QI)!
4. Idea for meeting 1031 45 Day Deadline
Another tool in your tool belt: there are companies that specialize in passive income properties that are structured to qualify for use in a 1031 exchange. These companies structure their properties for fractional ownership, meaning that you can 1031 out of a property that you solely own and manage into a piece of a larger property (or portfolio) that already has management in place. You can still take your depreciation and everything. It's full real estate ownership. Many of these properties/portfolios are "syndicated" so that the sponsor of the offering holds onto it and sells each piece off to an investor, one at a time, to accommodate their unique 45/180 day deadlines. Point being that you can ID one or two of these (e.g. TIC or DST) properties as your 2nd or 3rd choice while you're looking around for your ideal replacement property. If you can't find exactly what you want (or if it falls through) you can just close on one of these properties to complete your exchange, saving you on capital gains and depreciation recapture taxes and getting you cash flow (often starting at around 7% or so) until you are ready for another exchange (assuming 1031s are still legal by then). [Full disclosure/disclaimer: my own company operates in this space, providing access to these kind of passive income properties structured for 1031 exchange.]
5. Ownership and Use Req. for 121
It sounds like you are already familiar with the ownership and use requirements of the 121 Home Sale Exclusion, but either way, here is how I like to think about it (just in case it helps here):
1. The Home Must Be Owned for a Total of at Least Two Years During the Five-Year Period Leading Up to the SaleIn order to legally shelter the proceeds received from the sale of one’s home, a taxpayer must own the home for an aggregate of two years prior to the sale. This ownership does not have to be continuous; it may be broken up or interrupted, so long as the total duration of ownership adds up to at least two years and occurs within the five-year period leading up to the sale of the home.
2. The Home Must Be Used as the Taxpayer’s Principal Residence for a Total of at Least Two Years During the Five-Year Period Leading Up to the Sale
In addition to the ownership requirement, to shelter gain from the sale of a home from taxable recognition, the home must also be used as the taxpayer’s principal residence for an aggregate of two years during the five-year period leading up to the sale of the home. This use does not have to be continuous; it may be broken up, so long as the total duration of use adds up to at least two years and occurs within the five-year period leading up to the sale of the home. Additionally, short vacations and seasonal absences may be included in the use period, even if the residence is rented out during these absences.
Determining the “principal” residence of a taxpayer involves consideration of several factors, including where the taxpayer works, where the taxpayer’s family lives, the taxpayer’s mailing and billing addresses, the location of the taxpayer’s banks, and the location of the taxpayer’s religious and recreational activities. This also means that the Home Sale Exclusion cannot be taken on more than one home at a time.
There are a few exceptions to the use requirement for out-of-residence care, unforeseen circumstances, and uniformed, military, and intelligence service.
NOTE: The Periods of Ownership and Use of the Home Do Not Have to CoincideThe requirements for ownership and use of the home may be satisfied during non-concurrent periods so long as both of the requirements are met during the five-year period leading up to the sale. This may be helpful for a tenant who rents a home prior to buying it.
