Playing 1031 Jenga™? Don’t let the Deal Collapse!

Thursday, August 04, 2016 by David Gorenberg

An interesting issue regarding multi-family properties has been raised several times this week. With slight variations, the essential question is whether the taxpayer can live in one of the units in a multi-family property and still participate in a valid 1031 exchange.

A portion of the relinquished property is primary residence

In the first scenario, Sarah owns a four-unit building, and she lives in one of the units. She is selling the building for $1,500,000 and wants to understand whether she can do an exchange, and how to structure it. Conveniently for Sarah, for tax purposes, her accountant has been allocating 75% of the property taxes and related expenses to the rental units, and 25% to her residence. Thus, upon sale of the building, $375,000 (25% of $1,500,000) can be allocated to the sale of her residence, and the remaining $1,125,000 can be used for her 1031 exchange. Whether Sarah acquires replacement property where she will live in one of the units is entirely up to her. There is no requirement that she continue with those arrangements in the replacement property. But she certainly will want to ensure that she buys replacement property valued at or above the $1,125,000 allocated to the investment portion of this property, if she wants to fully benefit from a 1031 exchange.

A portion of the replacement property is primary residence

In the second scenario, Rachel owns a duplex that she has rented out since she bought it. She is selling the building for $1,500,000 and wants to know whether she can buy a triplex where she will live in one of the units. Much like Sarah’s situation, Rachel will need to allocate the proceeds of her exchange into the replacement property. Assuming that the triplex is comprised of three units of equal size and value, she will need to buy a triplex worth at least $2,250,000 if she wants to fully benefit from a 1031 exchange. In doing so, she will be able to allocate the $1,500,000 toward her 1031 exchange replacement property, and the remaining $750,000 toward her residence.

Replacement property is of lower value than relinquished property

Similarly, what if Rachel is using her $1,500,000 in exchange funds to buy Sarah’s four-unit building, and wants to live in one of the units? Remember that Sarah’s building is selling for $1,500,000. Since Rachel will be living in one of the four units, the value of the remaining three units as replacement property is only $1,125,000. Since Rachel sold her first investment property for $1,500,000, the $375,000 that she has not reinvested at this time would represent a taxable event. She could either (a) pay the taxes, (b) buy another property worth at least $375,000, or (c) not live in one of the four units.

As with any legal matter, advance planning is the key to success. Our team of 1031 exchange attorneys, working with our clients and their legal counsel, have successfully guided our clients through 1031 exchanges involving this scenario on many occasions.

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