Living in one unit of a multi-family property while renting out the others is a smart strategy many real estate investors use to get started or to maximize their investments. It’s a great way to generate rental income while also covering your own housing needs. But what happens when it’s time to sell and you want to do a 1031 exchange? How do owner-occupied multi-family properties in 1031 exchanges fare? Does your personal use of one unit muddy the waters? Let’s dive into this complex but common scenario.

The Appeal of Owner-Occupied Multi-Family Properties

It’s easy to see why this strategy is popular. You get to keep a close eye on your investment, potentially qualify for owner-occupied financing rates, and offset your own housing costs with rental income from the other units. It’s a win-win… until you decide to sell and want to take advantage of a 1031 exchange for your multi-family property.

The 1031 Exchange Dilemma with Owner-Occupied Multifamily Properties

Here’s where things get tricky. The IRS rules for 1031 exchanges are clear: the properties involved must be held for productive use in a trade or business or for investment. Personal residences don’t qualify. So, what happens when your property is a bit of both? This is a common issue with owner-occupied multi-family properties in 1031 exchanges.

Partial Exchanges: A Possible Solution

The good news is that the IRS does allow for partial 1031 exchanges. This means you might be able to do a 1031 exchange on the portion of the property used for investment purposes while dealing with the personal-use portion separately. This can be particularly useful for owner-occupied multi-family properties in 1031 exchanges.

How an Owner-Occupied Multi-Family Property 1031 Exchange Might Work:

Let’s say you own a fourplex. You live in one unit and rent out the other three. When you sell, you might be able to do a 1031 exchange on 75% of the property (the three rented units) while treating the sale of your personal unit as a regular home sale. Such scenarios often arise with owner-occupied multi-family properties in 1031 exchanges.

The Importance of Proper Allocation

If you go this route, it’s crucial to properly allocate the property’s value between personal use and investment use. This isn’t as simple as saying “I lived in one out of four units, so 25% was personal use.” The IRS will expect you to make a fair market value allocation, which might take into account factors like unit size, amenities, and location within the building. Correct allocation is essential for owner-occupied multi-family properties in 1031 exchanges.

Timing is Everything

Another key factor is timing. The IRS will look at how the property was used in the period leading up to the sale. If you moved out of your unit and rented it out for a significant period before selling (typically at least a year), you might have an easier time arguing that the entire property was held for investment at the time of sale.

The “Swap and Drop” Strategy

Some investors use a strategy called “swap and drop.” This involves moving out of the property, renting out your former unit, and then waiting for a period (again, typically at least a year) before selling. This can help establish that the entire property was held for investment purposes at the time of sale.

Proceed with Caution

While these strategies can work, they’re not without risks. The IRS scrutinizes 1031 exchanges carefully, and even more so when personal use is involved. It’s crucial to work with experienced professionals who can guide you through the process and help you document everything properly. This is especially important for owner-occupied multi-family properties in 1031 exchanges.

The Bottom Line

Selling an owner-occupied multi-family property and using a 1031 exchange is complex, but it’s not impossible. With careful planning, proper documentation, and expert guidance, you can potentially defer a significant portion of your capital gains taxes.

At WealthBuilder 1031, we specialize in helping investors navigate these complex scenarios. We can help you understand your options, develop a strategy that maximizes your tax benefits, and guide you through the entire process.

Thinking about selling your owner-occupied multi-family property? Or wondering if a 1031 exchange might be right for you? Don’t leave money on the table or risk running afoul of IRS rules. Give us a call at 888-508-1901. Let’s work together to turn your owner-occupied investment into the next step in your real estate journey.