If you are thinking of selling your dual use property – a primary residence property which is also used for business or investment purposes – you may qualify for the benefits of two sections of the Internal Revenue Tax Code. By combining IRC Sections 121 and 1031 in the same transaction, the portion of the property where the owner lives may qualify for the primary residence exclusion under Section 121 (a $250K gain exemption or $500K if married and filing jointly) and the portion of the property held for business, rental or investment use may qualify for a 1031 tax deferred exchange under Section 1031.
Examples of dual use property, also known as mixed use property, include: a duplex in which the taxpayer rents one unit and lives in the other unit; having a home office or operating a business out of a home; or a farm or ranch that includes a residence.
Your tax advisor will determine how to allocate the basis and gain for the portion used as residence and the portion used as business, rental or investment. This calculation may be based on the square footage, number of rooms used, or may be by appraisal. Expenses must then be divided appropriately and clearly.
Taxpayers can further apply this combination of the two tax sections to strategically maximize investment. In cases where a taxpayer wants to convert a previously exchanged 1031 property into a primary residence or will greatly exceed the Section 121 personal exemption gain, utilizing a strategic 121/1031 combination could be of great benefit.
For more information, refer to the guidance provided by the IRS in Revenue Procedure 2005-14 and discuss it with your tax advisor.