Tax benefits upon sale of owner-occupied small multifamily housing

When the owner of a duplex, triplex or fourplex lives in one of the units and rents the others, careful tax planning may make a future sale attractive.

Individuals and married couples may want to consider whether investment in a smaller rental property in which they would reside in one of the units is a smart idea now and looking ahead. Government-backed mortgages are available to eligible applicants for owner-occupied rental properties with two, three or four units.

The key to these mortgages is that the lenders will take into account for purposes of mortgage qualification the future rental income from the other units in the building. Counting the future rental income allows some buyers to qualify for mortgages they could not get if only earned income from wages was considered available to make the future mortgage payments.

This kind of real estate purchase creates an ownership situation that is partly residential and partly for investment. Two tax benefits may be available to such an owner in the case of future sale of the building: exclusion of capital gain on the residential unit and deferral of taxation on capital gain by exchanging the other units held for investment for like-kind real estate.

Section 121 capital-gain exclusion on primary residential property

In most situations, money an owner makes on the sale of his or her principal residence is excluded from being taxed up to $250,000 in gain for a single person and $500,000 for married couples filing taxes jointly. The owner must have used the home for his or her main residence for at least two of the five years before the sale.

This exclusion is available to a taxpayer once every two years.

In the case of owner-occupied rental property, that portion of the building that was used as the owner's residence would be proportionately eligible for the exclusion. Gain on the other units that were used as income-generating rental property would be normally subject to taxation, with some exception.

Section 1031 exchanges

One way the owner could get more favorable tax treatment in such a sale would be to exchange the rental portion of the property for another like-kind property by reinvesting the proceeds of the first property into the similar second one. Section 1031 of the Internal Revenue Code allows the deferment of tax on capital gains when a property used for investment or in a trade or business is essentially swapped for another similar one.

Payment of tax on the gain is postponed until the second exchanged-for property is sold (or if it is exchanged again, when the chain of qualified exchanges finally results in a sale).

Get thorough legal advice

Transactions involving sections 1031 and 121 can be very complicated. Consult an experienced real estate lawyer for legal and tax advice if you are considering buying, selling, transferring or exchanging a small rental unit in which you both reside and rent out the other units to others. Your attorney can advise you about the related tax issues and educate you about the pros and cons of the options available to you. Legal counsel can also draft or review any necessary legal documents to accomplish your goals.

In addition, the allocation of gain between the residential and business parts of the property as well as the tax treatment of each part must be carefully and professionally assessed and reported.

With offices in Brooklyn, New York, the attorneys at Polizzotto and Polizzotto, LLC, assist both local and out-of-state clients in a wide variety of real estate matters concerning property in New York or New Jersey.