1031 Exchange for a Mixed-Use Building

The unit you live in is a home sale; the storefront and rental units are an exchange

Reg. §1.121-1(e)(1) denies the home-sale exclusion to any portion of a property separate from your dwelling unit that you did not use as your residence, and Publication 523 gives the exact case: a store building with an upstairs apartment in which you lived. Your apartment is a residence; the shop and the other apartments are investment property.

The two parts are allocated by the same method you used to compute depreciation, normally square footage, under Reg. §1.121-1(e)(3). The residence share of the price is yours in cash if the gain fits the $250,000 single or $500,000 joint limit of §121(b); the investment share is exchange property that must reach the qualified intermediary.

You need two of the last five years of ownership and use in the unit, and no other §121 sale in the previous two years. If you moved into the apartment after renting it out, the nonqualified-use rule in §121(b)(5) reduces the exclusion, explained on the former home converted to rental page.

• Residence share: §121 exclusion, cash to you, gain above the limit taxed as capital gain
• Investment share: §1031 exchange, proceeds to the intermediary, depreciation deferred
• Allocation: the same square-footage split you used on your depreciation schedule

Rev. Proc. 2005-14 in order: exclusion first, then exchange, worked for a three-story main-street building

Rev. Proc. 2005-14 applies §121 to the gain before §1031, lets §1031 defer the post-1997 depreciation that §121(d)(6) cannot exclude, and adds excluded gain to the basis of the replacement property. Its Example 2 allocates a house and separate guesthouse two-thirds and one-third by square footage, excluding $100,000 on the residence while deferring $80,000 on the business part.

Hypothetically, you bought a three-story building for $600,000 with $450,000 to the structure, live on the top floor, and rent the shop and the middle unit. The rental two-thirds carries $300,000 of building basis and about $115,000 of 39-year depreciation; you sell for $1,500,000 with $60,000 of costs, an amount realized of $1,440,000.

Residence third: $480,000 realized less $200,000 basis is a $280,000 gain, fully excluded on a joint return and $30,000 taxable for a single filer. Investment two-thirds: $960,000 realized less $285,000 adjusted basis is a $675,000 gain, all deferred if the replacement is worth at least $960,000 with any debt replaced, including the $115,000 of depreciation. You leave closing with $480,000 of cash from the residence and a $960,000 exchange in the intermediary's account.

• Amount realized: $1,440,000 = $480,000 residence + $960,000 investment
• Gain: $280,000 excluded under §121 + $675,000 deferred under §1031
• Reported on two Forms 8824 used as worksheets, one per portion, per the 2025 instructions; the rental part also goes on Form 4797

Separate units mean the exclusion cannot soak up boot on the exchange side

Rev. Proc. 2005-14 counts boot on the business property only to the extent it exceeds gain excluded on that same business property, but that offset exists only when residence and business share one dwelling unit, as in its Example 3, where a home office inside a house gets a partial exclusion. A storefront below and an apartment above are separate dwelling units, so the shop's gain gets no exclusion and any cash you keep from the investment share is taxed as ordinary boot.

Vacancy does not change eligibility: an empty shop is still held for investment. A unit occupied rent-free by family is personal-use property that neither excludes under §121 nor exchanges under §1031, so put it on a market lease well before the sale or accept that its share is a taxable sale.

The 80% test sets your depreciation life, not your exchange, and it counts your own unit

Under §168(e)(2) a building is 27.5-year residential rental property only if 80% or more of its gross rental income comes from dwelling units, and the rental value of the unit you occupy is included in that figure. A building where the shop pays 30% of the rent is 39-year nonresidential property, which is why the example above uses 39 years.

Whichever life applies, straight-line depreciation on the rental share is unrecaptured §1250 gain at a maximum 25% (Topic 409) if you sell without exchanging, and it is deferred in full when you do. If the building qualified as 27.5-year property instead, the deferred amount is the same; only the annual deduction differed.

Replacement: pure apartments, a net-lease storefront, another mixed-use building, or DSTs for the exchange share

The $960,000 of exchange proceeds can buy any investment real estate: a small apartment building (multifamily), a single-tenant net-lease store (triple net), another main-street building where every unit is rented, or DST interests sized to the dollar (DST minimums and sizing). The $480,000 from the residence is unrestricted and can fund your next home or be added to the exchange as extra equity.

You cannot move into the replacement and call it done: property acquired in an exchange must be held for investment, and §121(d)(10) blocks the exclusion for five years after a like-kind acquisition. The 1031 CORP note on mixed-use exchanges lists owner-occupied duplexes and bed-and-breakfasts as replacements where the same split applies again.

If only the storefront is being sold, for example after a condominium split, the exchange covers that sale alone and your apartment stays outside it. Confirm the allocation percentages and both computations with your CPA or attorney before the listing goes live, because the square-footage split you used for depreciation is the split you are held to.