When it comes to a 1031 exchange, your primary residence is generally excluded. According to the rules of Section 1031 of the Internal Revenue Code (IRC), property used for personal purposes, like a primary residence, doesn’t qualify for tax deferral. The law only applies to properties that are “held for productive use in a trade or business or for investment.”

However, there are situations where your primary residence is part of a property with business or investment land, and in these cases, a Mixed-Use 1031 Exchange may apply.

Mixed-use property and a 1031 Exchange

A mixed-use exchange happens when the property being sold includes both a primary residence and land or structures used for business or investment purposes. Part of the property may qualify for a 1031 exchange in these scenarios, while the residential portion could be eligible for Section 121 benefits (more on that in a minute).

Examples of mixed-use properties include:

• A home office where a business rents space in your house.
• A farm or ranch where you work the land as a business but live on the property.
• A duplex where you live in one unit and rent out the other.
• A single-family home with an accessory dwelling unit (ADU) that you rent out while living in the main home.

As long as part of the property is used for business or investment, it could potentially qualify for a mixed-use 1031 exchange.

The IRS Code: Section 1031 and Section 121

Here’s the breakdown: Section 1031 allows you to defer capital gains taxes on properties used for business or investment when you exchange them for similar properties. Meanwhile, Section 121 allows homeowners to exclude up to $250,000 ($500,000 for joint filers) of capital gains on the sale of their primary residence if they’ve lived there for at least two of the last five years.

So how do you take advantage of both sections? It’s all about identifying your “principal residence”—which is typically your primary home (not your vacation home). Your primary residence can also include parts of a property that are used for business or investment.

Key Questions About Combining Sections 1031 and 121

How is the Section 121 exclusion calculated? The calculation of the exclusion for your primary residence involves determining the original purchase price of your home, the cost of improvements, and the value of the residential portion of the property being sold. You can determine the value with a market analysis from a realtor or an appraisal. For joint filers, the exclusion can be up to $500,000, while single filers get a $250,000 exclusion.

A common issue arises when a property has both a personal residence and a 1031-eligible business portion, and no value is explicitly allocated between the two. A current market analysis or other valuation methods can help. Consider factors like the per-acre value of the residential part compared to the larger investment property and the home’s insurance value.

How is the homesite defined? When valuing the residential portion of a mixed-use property, it’s helpful to think of the land and features that contribute to your enjoyment of the home—this could include gardens, septic systems, small pastures, and more. Using aerial photos is often a smart way to determine the homesite’s boundaries and help make the valuation more precise.

A Hypothetical Example

Let’s walk through a simple example:

• Total sale price: $2,500,000
• Residential portion: $800,000
• Basis in the primary residence: $300,000
• Section 1031 portion: $1,700,000

In this case, the primary residence portion is valued at $800,000, so the taxpayer could exclude the gain on that amount (up to $500,000 for joint filers, $250,000 for singles).

Applying the 121 Exclusion to Debt Payoff

One of the benefits of using the Section 121 exclusion is that you don’t have to reinvest the sale proceeds in another property. If there’s debt associated with the property, the Section 121 exclusion can help cover the debt payoff. In our example above, if the taxpayer owes $500,000 in debt, they can apply the 121 exclusion to cover that, meaning they don’t need to replace the debt with new debt in the 1031 exchange portion of the transaction.

How is the 121 Exclusion Documented?

The key to documenting the allocation of proceeds is ensuring there’s a clear separation between the 1031 exchange portion and the personal residence exclusion. The settlement statement from the sale will have line items showing both: one for “cash to exchanger (personal residence)” and another for “exchange proceeds to seller” (handled by the qualified intermediary).

When Doesn’t Section 121 Apply?

Section 121 won’t work if the property is part of a business held by a corporation or partnership—since these entities can’t own a primary residence. However, if you’re an individual or a disregarded entity like a single-member LLC or sole proprietorship, you can use the exclusion. It’s also possible to distribute the personal residence out of a business entity before the sale, but you’ll need to plan ahead—this needs to happen at least two years before the sale.

Final Thoughts

The Section 121 exclusion can give you a significant tax break by putting cash in your pocket without the need to reinvest. For mixed-use properties, taxpayers can use the Section 121 exclusion for the residential portion of the sale, while using Section 1031 for the business or investment portion. Keep in mind, though, that when participating in a 1031 exchange, your intent must be to hold the replacement property for productive use or investment in the long term.

It’s crucial to consult with a tax or legal advisor when structuring a 1031 exchange or when considering any changes to your investment property.