PART RESIDENTIAL (PERSONAL USE),
PART INVESTMENT PROPERTY

Because of the $250,000/$500,000 capital gains exclusion from the sale of a personal residence, the game has dramatically changed for owners of property that is
now part residence/ part investment.

It may be desirable to convert all of the investment portion of the property into personal residence use to be eligible for the enhanced capital gains tax exclusion from the sale of residence.

Example:  Dave and Sally own a waterfront duplex property one-half of which they have occupied as their personal residence and one-half of which they have treated as an investment property for the last 25 years.   Dave and Sally have decided that they are tired of being in the landlord business and wish to sell their property without reinvesting in a new rental property.

Dave and Sally  have taken depreciation deductions of $40,000 for the investment portion of the property. Their basis in the property is now comprised of the land value for the investment portion ($10,000) and the original cost basis ($50,000) of the residential portion of the property.  Their property has the following characteristics:

Here is an analysis of what would happen upon the sale of the Property in its present part residence part investment configuration;

Residence Portion		Investment Portion
$200,000	Value	$200,000
100,000	Debt	100,000
20,000	Closing costs	20,000
80,000	Equity	80,000
180,000	Adjusted Sales Price	180,000
50,000	Basis	10,000
130,000	Capital Gain	170,000
-0-	Taxable Gain	170,000

 If Dave and Sally were to sell the property, they would pay $36,000 in capital gains tax computed as follows:  of the $170,000 in capital gain,

$  40,000 in depreciation deductions is taxed at 25%=	$10,000
$130,000 in appreciation is taxed at 20%=	$26,000
To make a total capital gains tax of:	$36,000

Dave and Sally decide to convert one-half of the property (all of the investment portion) into their residence and wait the appropriate period of at least 2 years before selling their now all residence property.    Here is how their sales transaction would be structured and the resulting tax liability:
                            On the Sale of the Property:

Residence Portion		Investment Portion
$400,000	Value	$-0-
200,000	Debt	-0-
40,000	Closing Costs	-0-
160,000	Equity	-0-
360,000	Adjusted Sales Price	-0-
60,000	Basis	-0-
300,000	Capital Gain	-0-

Tax on this transaction:   would be limited to post May 1997 depreciation deductions taken.  $500,000 of gain from the sale of a residence is excluded from tax. 
 
Because of the elimination of the residential rollover, it may be desirable to convert part of the personal residence into a rental property which would be eligible for a Section 1031 exchange. 
 
Example:  Dave and Sally own a personal residence which they have occupied as their primary residence for the last 25 years.  The property has appreciated substantially over the years and has the following characteristics:

Fair Market Value:	$1,300,000
Debt:	600,000
Closing Costs on Sale:	100,000
Adjusted Sales Price:	1,200,000
Basis in the Property:	200,000
Capital Gain on Sale:	$1,000,000

If Dave and Sally were to sell the property, they would pay $100,000 in capital gains tax computed as follows:

Capital Gain	$1,000,000
Less personal residence exclusion	-$500,000
Equals taxable capital gain	$500,000
20% tax =	$100,000

Dave and Sally decide to convert one-half of their residence into a rental property and wait the appropriate period (probably at least two years) before selling their residence/investment property.  Dave and Sally have found an investment property that will cost $600,000 for which they will pay cash.  The resulting tax liability on the Sale of the Property:

Residence Portion		Investment Portion
$650,000	Value	$650,000
300,000	Debt	300,000
50,000	Closing Costs	50,000
300,000	Equity	300,000
600,000	Adjusted Sales Price	600,000
100,000	Basis	96,500*
$500,000	Capital Gain	$503,500

*assuming 2 years depreciation deductions taken of $3,500
       
The tax upon the acquisition of the new property under Section 1031:

Value	$600,000
Debt	-0-
Closing Costs	$1,000
Equity	$601,000
Basis	$96,500
Capital Gain Postponed	$503,500

Tax on this transaction:

On the residential portion:	-0-	$500,000 of gain excluded from tax
On the investment portion:	-0-	$503,500 of gain postponed

In the above case, it will be important to establish a defensible valuation approach for the investment portion of the property.  Reporting  steps must be taken on the tax returns ( probably safest to use two tax returns) to show the conversion of a portion of the former residence property into investment use.

The exchange documentation should reflect that the Exchangor is exchanging only part of the Relinquished Property under Section 1031 and should also reflect the remaining value is being treated as the personal residence of the Exchangor.

The escrow documents should reflect two separate sales transactions.  A separate settlement statement should be provided for the investment portion of the property (Section 1031) and the residential portion of the property.

The sales proceeds should be disbursed with the residential portion of the proceeds paid directly to the Exchangor and the investment portion of the proceeds paid to the Facilitator.

COMPARISON OF REQUIREMENTS UNDER SECTION 1031
AND RESIDENTIAL GAINS EXCLUSION RULES

Item	1031 Requirement for Total Deferral	Residential Gain Exclusion Rule
Use of Property acquired:	Investment/ Business	Primary residence
Value of New Property:	Equal or greater than Old Property	No requirement to match value
Debt amount on New Property:	Meet or exceed amount on Old Property	No requirement to match debt
Cash to buy New Property:	At least equal to cash from sale of Old Property	No requirement to use cash to buy New Property
Time to complete:	45 days to I.D./ 180 days to close from date of closing of Old Property	No time deadline
Holding period requirement:	No specific time intent controls	Must have owned & occupied as primary residence 2 of last 5 years
Time before you can exchange again:	No specific time intent controls	No more often than every 2 years
Postponement of tax on gain:	Available	Not applicable
Total shelter on $250,000 or $500,000 of gain:	Not applicable	Available
Necessary Advisors:	Realtor, CPA, and Facilitator or Tax Attorney	Realtor and CPA