When it comes to issues related to capital gains taxes associated with the sale of real estate, there are two primary provisions of the tax code that apply, IRC Section 1031 and IRC Section 121. Many people are unaware that when a property is used as a personal residence as well as for business or investment purposes, it is a mixed-use property that can benefit from both provisions of the tax code at the same time. Some examples of this are:
- a home office;
- a property that has an owner-occupied residence as well as a separate unit that is rented, such as an accessory dwelling unit (ADU) or portion of the property that is rented on Airbnb or VBRO;
- a duplex with the owner residing in one unit and a tenant in the other; and
- a farm or ranch where a portion of the property is owner-occupied
The basic requirements for tax exclusion or deferral under IRC Section 121 and Section 1031 are:
IRC Section 121
When a personal residence is sold, IRC Section 121 allows for capital gain exclusion of up to $250,000 if a taxpayer is single, and up to $500,000 if a taxpayer is married and filing a joint return, as long as the property has been the primary residence of the taxpayer for an aggregate of two of the preceding five years before the sale. The Section 121 exclusion may be utilized once every two years.
IRC Section 1031
The 1031 tax-deferred exchange is widely known and utilized by investors to defer capital gains tax when selling and buying investment property. To qualify under IRC Section 1031 the basic requirements to maximize tax-deferral are:
- Acquire “like-kind” property to be held for investment or productive use in a trade or business;
- Identify replacement property within 45 days of closing the relinquished property;
- Reinvest all cash and acquire replacement property(ies) of the same value or more 180 days from the first closing;
- The same taxpayer that sells the relinquished property acquires the replacement property; and
- Use of a qualified intermediary to meet the safe harbor.
When selling a mixed-use property, a portion of the gain from the sale of the personal residence may be exempt from tax under IRC Section 121, and the remaining tax may be deferred under IRC Section 1031. Your tax advisor can help determine how to allocate the basis and gain between the part of the property used as a home and the part of the property used as a business or rental.
Understanding the tax saving strategies available, along with proper planning and tax advice, can help save tax dollars! For additional information about the tax-deferred exchange and these concepts, contact your local representative at First American Exchange Company.