Section 1031 deals have strict guidelines

  • Steve Tytler / Herald columnist
  • Saturday, January 14, 2006 9:00pm
  • Business

Question: When you sell a duplex where you live in one unit and the other unit is a rental, do you have to do a 1031 tax-deferred exchange or would part of the duplex be classified as a personal residence?

J.W., Marysville

Answer: The short answer is “yes.” Under tax law, you may sell your principal residence and keep any profits up to $250,000 per person ($500,000 for a married couple) tax-free. No longer do you have to buy a replacement home of equal or greater value to avoid paying capital gains tax. But investment property owners are still subject to the capital gains tax on their property sale profits – unless they exchange the funds into another investment property.

In your case, your duplex is both your primary residence and an investment property. Therefore, from a tax standpoint, you must handle each portion of the property sale separately.

The portion of the duplex that is used for your residence can be sold tax-free, as long as you have owned the property for at least two years and your capital gain does not exceed $250,000. As I explained in this column last month, you can also avoid paying capital gains tax on the rental portion of the duplex by using the Internal Revenue Code Section 1031 exchange procedures. These rules are very strict and they must be followed to the letter, or your capital gains will become taxable. In order to qualify for a 1031 tax-deferred exchange, you must purchase a replacement investment property of equal or greater value than the property you are selling.

In your case, the replacement investment property would only have to be of equal or greater value than the investment portion of your duplex. For example, if your duplex sold for $400,000, with half of the value being allocated to the rental unit, you would have to purchase a replacement investment property that cost $200,000 or more to qualify for the exchange. Another requirement is that the replacement property must be “like kind,” which means it is held for investment or use in a trade or business.

That does not mean that you if sell a duplex you have to buy another duplex. You could replace the duplex with any kind of property, as long as it is held for investment or business use. For example, you could trade up from your duplex into a fourplex or a small apartment building, or you could buy a single-family rental house or even raw land – as long as the purchase price of the replacement investment property is equal to or greater than one-half the sales price of your duplex.

The time limit for completing a tax-deferred exchange is fairly short. You must identify the replacement investment property within 45 days of the closing date on the sale of your duplex and you must close on the purchase of replacement property within 180 days of the closing date on the old property. That doesn’t allow a lot of time for shopping around. Smart investors try to give themselves a little more breathing room by writing in a long escrow period on the sale of their investment property. For example, the purchase and sale agreement might state that the sale shall close 90 days after signing by all parties. That gives the investor an extra three months to locate an acceptable replacement property.

Another important 1031-exchange rule is that the seller cannot have any access to the cash proceeds from the sale of the investment property during the exchange period. This is called “constructive receipt,” and even if the sellers don’t do anything with the money, it is treated as taxable income regardless of whether they buy a replacement property. To avoid this situation, cash from the sale of an investment property in a 1031 exchange is typically held by a neutral third party called an exchange facilitator, who then purchases the replacement investment property on behalf of the exchanger.

The exchange process gets more complicated when you combine investment and residential use in a single property, as in your case. Before signing any agreements to buy or sell an investment property, be sure to consult a tax adviser and an exchange facilitator. Too often, I’ve heard sad stories of investment property sellers who could have saved thousands of dollars in capital gains tax if only they had taken the time to properly structure the transaction as a 1031 tax-deferred exchange before the sale. Once you sell the property and receive the cash, it’s too late to do a 1031 exchange because you have constructive receipt of the sale proceeds.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435 or e-mail him at economy@heraldnet.com

Talk to us

> Give us your news tips.

> Send us a letter to the editor.

> More Herald contact information.

More in Business

Izaac Escalante-Alvarez unpacks a new milling machine at the new Boeing machinists union’s apprentice training center on Friday, June 6, 2025 in Everett, Washington. (Olivia Vanni / The Herald)
Boeing Machinists union training center opens in Everett

The new center aims to give workers an inside track at Boeing jobs.

Some SnoCo stores see shortages after cyberattack on grocery supplier

Some stores, such as Whole Foods and US Foods CHEF’STORE, informed customers that some items may be temporarily unavailable.

People take photos and videos as the first Frontier Arlines flight arrives at Paine Field Airport under a water cannon salute on Monday, June 2, 2025 in Everett, Washington. (Olivia Vanni / The Herald)
Water cannons salute Frontier on its first day at Paine Field

Frontier Airlines joins Alaska Airlines in offering service Snohomish County passengers.

Amit B. Singh, president of Edmonds Community College. 201008
Edmonds College and schools continue diversity programs

Educational diversity programs are alive and well in Snohomish County.

A standard jet fuel, left, burns with extensive smoke output while a 50 percent SAF drop-in jet fuel, right, puts off less smoke during a demonstration of the difference in fuel emissions on Tuesday, March 28, 2023 in Everett, Washington. (Olivia Vanni / The Herald)
Sustainable aviation fuel center gets funding boost

A planned research and development center focused on sustainable aviation… Continue reading

Helion's 6th fusion prototype, Trenta, on display on Tuesday, July 9, 2024 in Everett, Washington. (Olivia Vanni / The Herald)
Helion celebrates smoother path to fusion energy site approval

Helion CEO applauds legislation signed by Gov. Bob Ferguson expected to streamline site selection process.

FILE — Jet fuselages at Boeing’s fabrication site in Everett, Wash., Sept. 28, 2022. Some recently manufactured Boeing and Airbus jets have components made from titanium that was sold using fake documentation verifying the material’s authenticity, according to a supplier for the plane makers. (Jovelle Tamayo/The New York Times)
Boeing adding new space in Everett despite worker reduction

Boeing is expanding the amount of space it occupies in… Continue reading

Water drips from an Alaska Airlines Boeing 737 after it received a water salute while becoming the first scheduled 737 arrival Thursday, Feb. 17, 2022, at Paine Field Airport in Everett, Washington. (Ryan Berry / The Herald)
Boeing and Airbus forecast strong demand for their jets

Boeing and Airbus project more than 40,000 new jets are needed.

Hundreds wait in line to order after the grand opening of Dick’s Drive-In’s new location in Everett on Thursday, June 12, 2025 in Everett, Washington. (Olivia Vanni / The Herald)
Dick’s Drive-In throws a party for opening day in Everett

More than 150 people showed up to celebrate the grand opening for the newest Dick’s in Snohomish County.

Patrick Russell, left, Jill Russell and their son Jackson Russell of Lake Stevens enjoy Dick’s burgers on their way home from Seattle on Friday, Sept. 22, 2023 in Edmonds, Washington. The family said the announcement of the Dick’s location in Everett “is amazing” and they will be stopping by whenever it opens in 2025. (Olivia Vanni / The Herald)
Dick’s Drive-In announces details for Thursday’s grand opening in Everett

Dick’s will celebrate its second Snohomish County location with four days of festivities.

Support local journalism

If you value local news, make a gift now to support the trusted journalism you get in The Daily Herald. Donations processed in this system are not tax deductible.