Real Estate With Combined Use as Primary Residence and Investment Property
Many properties are used for more than one purpose during their ownership. A common example is a property that serves as both a primary residence and a rental or investment property. Understanding how the tax rules apply in these situations is essential for homeowners and investors planning a sale or exchange.
The two most relevant provisions of the Internal Revenue Code are:
Section 121 (Primary Residence Exclusion) – Allows homeowners to exclude up to $250,000 ($500,000 for married couples filing jointly) of gain from the sale of a primary residence, if ownership and use tests are met.
Section 1031 (Like-Kind Exchange) – Allows investors to defer gain from investment or business-use real estate by reinvesting into other like-kind property.
When a property has mixed use, both provisions may apply in the same transaction.
Examples of Combined Use
Multi-unit properties – The owner lives in one unit and rents the others.
Converted homes – A property begins as a primary residence but is later rented out.
Home with partial rental use – A basement apartment, garage apartment, or vacation rental unit within a residence.
Each scenario requires allocation between the personal residence portion and the investment portion.
Section 121 Treatment
To qualify for the Section 121 exclusion, the taxpayer must have:
Owned the property for at least two years, and
Lived in it as a primary residence for at least two of the last five years before the sale.
For the portion of the property used as a personal residence, gain may be excluded—up to $250,000 ($500,000 for married couples filing jointly).
However, after 2008, the Housing and Economic Recovery Act (HERA) introduced limits on excluding gain for periods of “nonqualified use” (time when the property was not a primary residence, such as rental years).
Section 1031 Treatment
The portion of the property used for investment or rental may qualify for tax deferral through a 1031 Exchange, provided:
The exchange involves real estate held for investment or business purposes.
IRS timelines (45-day identification, 180-day completion) are met.
This allows taxpayers to continue deferring gain on the investment portion while excluding gain on the residence portion.
Example
An investor owns a duplex for 10 years:
Lives in one unit as a primary residence.
Rents out the other unit.
Later sells the property for a $400,000 gain.
Result:
Section 121 Exclusion may apply to the portion of the gain attributable to the residence unit (up to $250,000 / $500,000).
Section 1031 Exchange may apply to the portion of the gain tied to the rental unit, allowing tax deferral if exchanged into another investment property.
Depreciation recapture on the rental portion must still be recognized and taxed as ordinary income.
Key Considerations
Allocation is required – Gain must be divided between residence and investment use.
Depreciation recapture applies – Even if Section 121 exclusion is available, depreciation claimed on the rental portion cannot be excluded.
Advance planning is critical – The order of personal vs. rental use, and timing of sale or exchange, affect eligibility for both provisions.
IRS Guidance – Revenue Procedure 2005-14 outlines how Sections 121 and 1031 can be combined in mixed-use situations.
Owning real estate that serves both as a primary residence and an investment creates valuable opportunities for tax planning, but also adds complexity. By applying Section 121 to the residence portion and Section 1031 to the investment portion, taxpayers may significantly reduce or defer their capital gains tax burden.
Because IRS rules on mixed-use properties are detailed and closely scrutinized, property owners should review their situation with experienced tax and legal advisors well before selling or exchanging.
