Can I 1031 a bed-and-breakfast or small inn that I live in?

The law splits an innkeeper's building into a home and a business

The home-sale exclusion and the exchange rules each claim part of the building. Reg. section 1.121-1(e) says section 121 does not apply to the gain on any portion 'separate from the dwelling unit' that you did not use as a residence, and borrows the definition of dwelling unit from section 280A(f)(1).

That definition carves out rooms 'used exclusively as a hotel, motel, inn, or similar establishment'. Guest rooms, guest baths and areas used only for paying guests are therefore outside your dwelling unit, and their share of the gain cannot be excluded. Held for productive use in your business, that share is what a 1031 exchange can defer.

Rooms used both by family and by guests are not used exclusively as an inn, so they stay within your dwelling unit. For mixed space inside the dwelling unit the regulation says 'no allocation is required', and the exclusion can cover its gain except the depreciation.

Rev. Proc. 2005-14 sets the order: exclude first, defer second

The procedure says section 121 'must be applied to gain realized before applying' section 1031. Its Example 2 involves a separate guesthouse used as an office: the gain on the house was excluded, the guesthouse gain could not be, and it was deferred under section 1031 because equal-value replacement business property was bought.

Allocation follows your depreciation records. Reg. section 1.121-1(e)(3) requires you to split basis and price 'using the same method of allocation' used for depreciation, and Rev. Proc. 2005-14 notes square footage is an appropriate method.

Depreciation is the one layer the exclusion never touches. Section 121(d)(6) excludes gain up to post-May 6, 1997 depreciation from the exclusion, and the procedure says 'section 1031 may apply to such gain'. Cash for the business portion is taxable only to the extent it exceeds the gain excluded on that portion.

Worked example: a $1,500,000 inn with one-third owner's quarters

Hypothetical, round numbers, married filing jointly; run your own numbers with your CPA. You sell your inn for $1,500,000. Basis is $600,000, and by square footage one-third is your private apartment and two-thirds is guest rooms used only for guests, on which you claimed $200,000 of depreciation.

Residential third: $500,000 of price less $200,000 of basis is $300,000 of gain, all excluded under the $500,000 joint cap if you meet the two-year tests. Business two-thirds: $1,000,000 of price less $200,000 of adjusted basis is $800,000 of gain, including the $200,000 depreciation layer.

Run the business portion through a qualified intermediary into $1,000,000 or more of replacement real property and the $800,000 is deferred. Your residential $500,000 is yours to spend on a new home, tax-free.

• Excluded under section 121: $300,000.
• Deferred under section 1031: $800,000, if the business share is fully reinvested.
• Taxed now: furniture, linens and goodwill sold with the inn, under their own rules.

Only the real estate goes through the exchange, and the replacement must be held for business or investment

Since 2018, section 1031 reaches only real property. Furniture, equipment, the business name and goodwill are allocated a separate price and taxed in the sale year; the process for an operating lodging business is set out in 1031 exchange of a hotel or motel.

If you buy another inn and live in it, only its business portion is replacement property, and the purchase price should be allocated the same way. Section 121(d)(10) also bars the exclusion on a later sale of property acquired in an exchange within five years of acquiring it; how to plan for that is in section 121 vs 1031 for a former home.

Innkeepers retiring from the business often move the business share into passive property

Many sellers want out of hospitality altogether. The business share can buy any U.S. real property, including a Delaware Statutory Trust interest that needs no management from you, while the excluded residential cash buys the next home. See from business owner to passive investor and traditional DST exchanges.

A trust interest trades control and liquidity for passivity, and its income depends on the property and sponsor. Weigh that against selling and paying the tax at retirement before you name anything on your day-45 list.