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Selling mixed use property

Posted by taxguru on November 28, 2007

Q:

Subject: Exchange Question

 

My wife and I live in the front house. When does the rental back house cease becoming a 1031?  Does not receiving rent make it no longer a 1031(for how long)? Is there a statute of limitations for it to qualify as exempt?  I don’t want to pay a capital gain tax on it when I sell this 2on1 Calif. property.

Tx,


A:

This is the kind of thing you really need to be handling with a professional tax advisor to ensure that you are doing things properly.

From your very short description, it sounds like you have what’s called a mixed use property; part residential and part rental.  For IRS purposes, it is treated the same as two separate properties, with the personal residence portion of interest and property taxes deducted on your Schedule A and the expenses for the rental portion on Schedule E.  The actual allocation of joint expenses may not be 50/50 if the two halves of the property are not equal in size and/or value.  An experienced tax pro can help you come up with an appropriate allocation between the two halves.  The cost basis of the property also needs to be allocated between the personal residence and rental portions, with deprecation claimed on the rental portion, which will reduce its cost basis (aka book value).

In regard to the treatment of a sale of the property, the portion of the sales price that is allocated to your primary residence will be treated as a Section 121 possibly tax free sale, as I have explained on my website.  

The portion of the sales price allocated to the rental half will not be eligible for the tax free exclusion, and will need to be set up as a Section 1031 exchange if the taxable gain warrants it.

If I’m reading into your question properly, and you are asking how long it will be until the rental portion of the property can become eligible for the tax free Section 121 treatment, the answer is never, as long as it is being rented.  If the tenants leave and you convert the rental part to be an extension of your own primary residence, the clock can start on the personal use test, which is generally two years.

You didn’t say how you acquired this current property.  As an added twist, if you acquired it via a 1031 exchange, you will have had to own it for at least a full five years prior to its sale in order to be able to utilize the Sec. 121 tax free exclusion.  Again, an experienced tax pro can assist you with this rule.

I hope I hit on your situation.  Working directly with a professional tax advisor will result in more usable numbers for your precise situation than the generalities I have to use.

Good luck.

Kerry Kerstetter

 

 

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