Commercial real estate tax when same building has a rental office and personal business office

A recent question:

My father has owned a commercial building in NJ for years. He is trying to retire now and plans on selling it. The building holds two separate offices. He has always worked out of one for himself and has always rented the other, earning (and paying taxes on) rental income. Upon the sale, is their a formula that Uncle Sam uses to figure out how the sale should be seen (sale as a rental property vs. sale as a place of business)? He is also thinking about using the rental sale proceeds for a 1031 Exchange and buying a retirement home near the Jersey shore that they would eventually retire to. In theory, he would rent it out for a few years and then move into it as their primary residence, when they sell the house they live in now. Is such a scenario a viable way to avoid capital gains taxes? If so, is if there is a minimum amount of years that the shore house must be held as a rental property before making it their primary residence, to avoid paying capital gains tax on it? Thanks in advance.

And some answers that came from an internet message board – don’t make any decisions until you verify this information:

I’ll answer the first question: use the same formula you used to allocated the basis for depreciation purposes between the business and the rental.

To answer your second question: I believe he should avoid capital gains tax. One may exchange a business property for rental property (in your case) and meet the requirements of IRC section 1031.

These rules generally provide that no gain or loss is recognized when business or investment property is exchanged solely for other business or investment property of like kind.

What is like-kind? Without going into it too much, real property exchanged for real property shall be considered like-kind provided that both properties are either business or investment properties. There are also some timing requirements that you must be met.

But if you plan to seriously enter into this transaction, please consult a professional.

For the shore house to be considered a primary residence you have to live there for two years.

And some more questions from someone who is trying to answer:

How was the property reported for tax return purposes – i.e., you mention that is is ONE building but TWO different offices (one rental real estate and one for your father’s business)? Was the rental real estate reported on one Schedule C of your father’s Form 1040 and was the office used for your father’s regular business reported on a separate Schedule C ? Or was your father’s business separately incorporated as C or an S corporation, or setup as an LLC ? Just curious because the way the two separate businesses have been reported may affect the way you want to handle the proceeds from a potential like kind exchange. I assume that when your father sells the building he will sell the whole building, thereby creating proceeds allocable to both the rental real estate business and his “regular” business. In other words, the building is not anything like a duplex where title can legally be sold to one unit (rental real estate part) and the other unit doesn’t have to be sold (father’s regular business).

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