MixeD-Use Properties

The Big Picture

Certain properties may qualify for the combined benefits of two tax code provisions, allowing for enhanced overall tax savings.

Why it Matters

Internal Revenue Code Section 121 provides for an exclusion of gain of up to $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly upon the sale of a principal residence. During the five-year period immediately preceding the sale, the taxpayer must have used the property as a principal residence for a cumulative period of at least two years.

Internal Revenue Code Section 1031 allows for tax deferral when a taxpayer sells real estate held for business or investment and purchases real property held for business or investment if certain procedures are followed.

Mixed-Use Properties

A taxpayer may own a home as the principal residence but part of the property may have been used as an investment or in connection with a business or trade, creating an exchange-eligible component. This is known as a mixed use property. Examples:

• An equine veterinarian who treats horses on the land on which sits her primary residence.
• A multi-unit property in which the owner lives in one of the units and rents the others out.
• A property with a separate house or even internal unit that is rented out.
• A rural landowner lives in a home on part of the property while using the remaining acreage for farming, ranching, or simply holding the dormant land or pasture for long-term appreciation.

In these instances IRC Section 121 may be used for tax exclusion and IRC Section 1031 can both be used for tax deferral. The property owner, in consultation with a tax advisor, must allocate the portion of the sales proceeds attributable to the part of the property that is used as a primary residence for tax exclusion under Section 121. The remaining proceeds usually qualify for Section 1031 tax deferral.

At closing, the landowner may receive the net sales proceeds allocated to the primary residence directly from the title company. Before the sale closes, a 1031 qualified intermediary must be in place for the business or investment portion of the property. The property owner must meet all other requirements necessary for a 1031 exchange.

The Takeaway

When selling mixed-use property, taxpayers can achieve some tax exclusion under Section 121 for the primary residence and defer the tax for the business or investment portion of the property under Section 1031. Work with your tax advisor to determine the allocation of sales proceeds and communicate with the title company and 1031 qualified intermediary.

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