 Carving
out a homestead from investment
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 Dear
Tax Talk,
I am in the process of a 1031 exchange. I am selling some oceanfront
property in Hawaii for a larger parcel inland. The new parcel is
almost 20 acres and has a permanent income from a cell tower, so
it is definitely investment/business property. My question is, can
I build a home on the new property to live in? Does that jeopardize
the exchange? The property is still business property, in that the
income will still be there. Does what I put on the property later
change any of that? -- David
 Dear
David,
Do you worry more about the radiation from the
cell tower or the Internal Revenue Service irradiating your exchange
benefits? In a Section 1031 exchange, you change one property held
for investment or productive use in a business for another property
that will be similarly held.
The gain that you realize on the exchange is deferred
into the cost of the replacement property. If you later sell the
replacement property, you pay tax on the deferred gain plus the
appreciation in the replacement property. Any property you receive
in the exchange that is not similar is considered boot, or profit,
and makes the exchange partially taxable. Since admittedly you will
not hold the entire 20 acres of land for just a cell tower, the
part that you carve out for a home site will be considered boot.
For example, if you use one acre for a home site, the value of the
one acre will be taxable.
To illustrate, let's say the oceanfront property has
a cost basis for tax of $50,000 and the 20 acres is worth $200,000
or $10,000 an acre. You would pay tax on $10,000 and defer $140,000
in gain. Your cost in the 19 acres is $50,000 and in the one acre
is $10,000.
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