Section 1031 deals have strict guidelines

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

More in Herald Business Journal

Pilot Dan Tarasievich lines up for a landing at  Arlington Municipal Airport after a morning of flying with friends on Saturday, April 20, 2019 in Arlington, Wash. (Andy Bronson / The Herald)
Could Snohomish County’s two largest airports be expanded?

A study explores expanding runways at Paine Field and Arlington Municipal to relieve a coming crunch.

Alain Warchilde racks an e-bike available for Saturday's parking lot sale at Sharing Wheels in Everett on June 16, 2021.  (Kevin Clark / The Herald)
Need new-to-you bike? It’s time for a sale at Sharing Wheels

The Everett nonprofit kept fixing and donating bicycles in spite of pandemic closure and challenges.

Site preparation for housing development was underway Tuesday, June 8, at the property known as Frognal Estates near Edmonds. (Chuck Taylor / The Herald) 20210608
Site prep underway at contested development near Mukilteo

The site near Picnic Point recently sold for $24 million after the previous developer filed for bankruptcy.

A portion of the site of the proposed Lake Stevens Costco at the intersection of Highway 9 (right) and South Lake Stevens Road (below, out of view). (Chuck Taylor / Herald file)
Shovel alert: Groundbreaking on Lake Stevens Costco is near

A land sale in early June cleared the way. The mayor says dirt could be flying as soon as next week.

FILE - In this Feb.14, 2019 file photo, an Airbus A380, left, and a Boeing 747, both from Lufthansa airline pass each other at the airport in Frankfurt, Germany. The United States and the European Union on Tuesday appeared close to clinching a deal to end a damaging dispute over subsidies to Airbus and Boeing and lift billions of dollars in punitive tariffs. (AP Photo/Michael Probst, File)
Airbus-Boeing deal eases US-EU tensions but conflicts remain

For now, though, a truce in the Boeing-Airbus dispute goes a long way toward repairing a huge relationship.

The Everett Post Office is shown with a "now hiring" sign in 2019. (Sue MIsao / Herald file)
Washington unemployment rate dipped to 5.3% in May

Private sector employment increased by 7,000 jobs and government employment increased by 1,300 jobs.

Boeing 737 Max airplanes, including one belonging to TUI Group, left, sit parked at a storage lot, Monday, April 26, 2021, near Boeing Field in Seattle.  Lawmakers, on Tuesday, May 18,  are asking Boeing and the Federal Aviation Administration for records detailing production problems with two of the company's most popular airliners. The lawmakers are focusing on the Boeing 737 Max and a larger plane, the 787, which Boeing calls the Dreamliner.  (AP Photo/Ted S. Warren)
Biden administration talking to China on Boeing Max approval

The planes remain banned in the country while other jurisdictions have reauthorized it following crashes.

Pho
You voted: The best pho in Snohomish County

Even during a pandemic, people still have their favorites

Supporters march Wednesday afternoon across from Providence Medical Center in Everett on May 5, 2021. (Kevin Clark / The Herald)
Everett nurses threaten to strike as contract talks stall

Union leaders say Providence’s latest offer includes low wages and cuts to benefits and paid leave.

Most Read