1031 Strategies When Selling a Main-Street Mixed-Use Building

Section 121 runs first and section 1031 takes what survives it

Rev. Proc. 2005-14 is the only authority that tells you how the home-sale exclusion and the like-kind rules share a single closing, and its section 4.02(1) is blunt: the exclusion is taken against realized gain first, and only then does the like-kind rule work on what remains.

Two consequences follow. Section 121 cannot shelter gain attributable to depreciation taken after May 6, 1997 under §121(d)(6), but section 1031 can defer exactly that gain. And cash received in the deal is counted as boot only for the amount by which it overtops the excluded gain on the business portion.

The revenue procedure's own Example 4 shows the effect: a taxpayer receives $10,000 of cash, excludes $50,000 on the business share, and recognizes nothing, because the boot never rises above the excluded amount.

Worked example: a $900,000 building that is one-fifth residence and four-fifths income property

Use round hypothetical numbers. A single owner bought a storefront with three apartments above for $300,000, lives in one apartment, rents the other two and leases the shop, so by square footage the owner's own unit is 20% of the building. Depreciation of $120,000 has been claimed on the 80% that is business and rental space, and the building now sells for $900,000.

The residence share: amount realized $180,000 against a basis of $60,000, so $120,000 of gain, all excluded under section 121 because it is well inside the $250,000 limit and the owner meets the two-of-five-year test.

The income share: amount realized $720,000 against a basis of $240,000 reduced by $120,000 of depreciation, so an adjusted basis of $120,000 and $600,000 of gain. All $600,000, including the $120,000 attributable to depreciation, can be deferred by exchanging into replacement property worth at least $720,000. Have your CPA or attorney confirm the split against your own depreciation schedules.

• Residential 20%: $180,000 realized, $60,000 basis, $120,000 gain, excluded.
• Business and rental 80%: $720,000 realized, $120,000 adjusted basis, $600,000 gain, deferred.
• Replacement target for full deferral on the business share: $720,000 of like-kind value.
• Basis carried into the replacement: $120,000, plus any section 121 gain allocable to the business share.

Your own apartment is a separate dwelling unit from the shop, so you have to allocate

The distinction that decides this is whether the non-residential use sits inside your dwelling unit or outside it. Rev. Proc. 2005-14 paragraph .03 explains that where the business portion is separate from the dwelling unit used for residential purposes, the gain allocable to the business portion is not excludable unless you also met the two-year use test for that portion.

A ground-floor store and the tenants' apartments are plainly outside the unit you live in, using the section 280A(f)(1) meaning of dwelling unit, so allocation is required and the pattern follows the revenue procedure's Example 2 rather than its Example 3.

The contrast is worth knowing. In Example 3, an office occupying a third of a single house needs no allocation for the use test, and section 121 can shelter that third's gain apart from depreciation. A live-work loft with no physical separation can fall on that side of the line; a storefront almost never does.

Square footage is an accepted split, but it has to match how you depreciated

Reg. §1.121-1(e)(3) requires you to allocate basis and amount realized using the same method you used to determine depreciation adjustments, and the revenue procedure cites Poague v. United States as authority that square footage is an appropriate method.

That is a constraint, not a choice. If your depreciation schedules have used a 70/30 split for fifteen years, a 50/50 split at closing to enlarge the exclusion will not survive a look at the returns.

Where the store carries a far higher value per square foot than the apartments, an appraisal that allocates by value is defensible only if it is the method the depreciation followed. Fix the method before the listing, not on the settlement statement.

The 80% gross-rent test decides whether the replacement depreciates over 27.5 or 39 years

Mixed-use property has a second, quieter tax consequence. §168(e)(2)(A) defines residential rental property as a building where 80 percent or more of gross rental income for the year comes from dwelling units, and the statute adds that if you occupy part of the building, the rental value of your own space counts in that gross rental income.

Above the line, the recovery period is 27.5 years; below it, 39. On a main-street building where the commercial rent is a large share of the total, the whole structure is nonresidential real property and depreciates a third more slowly.

That makes the replacement choice a cash-flow decision as well as a risk decision. A pure apartment building restores the 27.5-year life on the carried-over basis, while a net-leased commercial replacement keeps you on 39 years.

If you may live in the replacement one day, a five-year clock starts at closing

§121(d)(10) denies the home-sale exclusion on any property you acquired in a section 1031 exchange if you sell it within five years of acquiring it, regardless of how long you lived there.

Section 121(b)(5) then limits the exclusion further by the periods of non-qualified use after 2008, so converting an exchanged rental into a residence gives you a partial exclusion at best. Former home turned rental and using a 1031 to buy a future retirement home cover that path in detail.

For most main-street sellers the cleaner plan is to keep the two halves apart: bank the section 121 exclusion on the apartment you occupied and move the income share into passive replacement property such as a traditional DST, a net-leased building or a direct title security. Breakwater Exchange is a 1031 exchange broker licensed in every state inside a regulated broker-dealer framework, after twenty-plus years of this work and a billion dollars and more of DST transactions. The form on this site opens the conversation.