1031 Exchange for a Duplex, Triplex or Fourplex

An $800,000 fourplex with $300,000 of gain: the first $100,000 is taxed at 25%, not the capital-gain rate

Suppose you paid $600,000 for a fourplex, deducted $100,000 of depreciation over the years and sell for $800,000 (hypothetical figures). Adjusted basis is $500,000, realized gain is $300,000, and the first $100,000 of it is unrecaptured section 1250 gain taxed at up to 25%, or $25,000.

The other $200,000 is long-term gain at 15% or 20% ($30,000 to $40,000), and the 3.8% net investment income tax on $300,000 adds $11,400, so the federal bill runs $66,400 to $76,400 before state tax. A completed exchange defers the whole amount and carries your $500,000 basis into the replacement.

Every 2–4 unit rental is 27.5-year residential rental property provided at least 80% of gross rents come from dwelling units, and the same class applies to a 30-unit building, so the recapture math is identical when you trade up.

Four units is the lending line: above it the loan is sized on the building's income

Fannie Mae's Selling Guide treats one- to four-unit investment property as residential: the appraiser uses the Small Residential Income Property report (Form 1025), and rental income from the subject property is counted at 75% of gross rent against the payment. Those programs stop at four units.

A five-unit or larger replacement is financed as multifamily, where the lender starts from net operating income and the coverage it must provide over debt service rather than from your personal income. Ask lenders early what coverage, reserves and recourse they require, because those terms decide how large a building your equity can carry.

That difference matters inside a 45-day window. A residential loan on a 2–4 unit replacement follows a familiar path; a commercial appraisal and underwriting on a 20-unit building take longer, so open the loan file before you close the sale.

Trading an $800,000 fourplex into a 12-unit building: the equation in numbers

Keep the example going with a $300,000 loan payoff and $40,000 of selling costs. Net sale price is $760,000 and the intermediary holds $460,000, so full deferral means a replacement costing at least $760,000, all $460,000 reinvested, and at least $300,000 of new debt or added cash.

A $1,500,000 twelve-unit building bought with $460,000 down and a $1,040,000 loan clears both tests. If the lender's coverage test caps the loan at $900,000, you either add $140,000 of your own cash or buy a smaller building; either choice keeps the deferral intact.

Reserves are the hidden line item: cash that goes into a lender-required reserve account instead of the purchase price is money you received, not real property. Fund reserves from outside cash rather than from the exchange account.

One fourplex into three houses or several DST slices: the three-property and 200% rules

Splitting is allowed. Identify up to three replacements of any value, or any number whose combined fair market value stays within 200% of the fourplex's value, which is $1,600,000 on an $800,000 sale.

DST fractional interests fit the 200% rule well because their prices are fixed by the offering, so you can name four or five trusts and still know the total. Direct purchases in different states work the same way, but every closing must happen by day 180.

Avoid the 95% rule as a fallback: if you exceed both limits, the exchange survives only if you actually acquire 95% of the total value you identified, so over-listing properties you may not close on is how identifications fail.

Living in one of the four units: §121 on your unit, §1031 on the other three

When you occupy one unit, the sale is two transactions in one deed. Rev. Proc. 2005-14 applies section 121 to the residence portion first, then section 1031 to the rental portion, allocating basis and price by a reasonable method such as square footage.

With four equal units, 25% of the $800,000 price and of the $600,000 cost belong to your home: a $50,000 gain that is excluded if you owned and lived there two of the last five years. The other 75% ($600,000 realized against $350,000 of adjusted basis, or $250,000 of gain) runs through the exchange, and depreciation claimed after May 6, 1997 cannot be excluded under section 121 but can be deferred under section 1031.

Only the rental share needs to be replaced: the intermediary receives the rental portion of the proceeds, and the home-sale cash comes to you tax-free.

What pushes small multifamily owners out, and the five checks before listing

The usual triggers are one roof, one sewer line and one boiler serving every unit, so a single failure hits all the rent at once, plus tenant turnover you handle yourself. Those are sound reasons to exchange into a managed building or a DST, but the swap only works if the paperwork is right before closing.

• Sign the exchange agreement with a qualified intermediary before the deed transfers; receiving the proceeds ends the exchange.
• Keep tenant security deposits and prorated rents out of the exchange proceeds; pay them to the buyer from your own funds so they do not become boot.
• Match the taxpayer: the same person or entity that sells must acquire, so decide on any LLC change with counsel before you list.
• Put the identification in writing, signed and delivered to the intermediary by day 45; an email to your agent does not count.
• Have your CPA or attorney confirm the residence allocation and the debt replacement before you sign the purchase contract.