Bifurcate: a verb meaning to divide into two branches or parts.

It's not uncommon for a real estate transaction to have two or more parts that are governed by different code sections. The one we see most often is the sale of a property that involves both 1031 investment property and a primary residence. A typical example of this is the sale of a farm. Let's assume that Fred is selling his farm, which is comprised of 1,000 acres of farmland, which includes a 5-acre parcel where his house and garage sit. This transaction can have two parts covered by different code sections.

by Gary Gorman founding partner, 1031 Exchange Experts, LLC

Let's assume that Fred is selling his farm, which is comprised of 1,000 acres of farmland, which includes a 5-acre parcel where his house and garage sit. This transaction can have two parts covered by different code sections.

Section 121 covers the 5-acre parcel with the house and garage. §121 is the IRS code section that provides that the first $500,000 ($250,000 if Fred is single) of gain from the sale of the residence is tax-free. And Fred is not required to buy another house with the tax savings—he can take the cash from the sale tax-free and do whatever he wishes with it.

The remaining 995 acres of farmland and outbuildings are covered by IRS code, Section 1031, since they're used in the farming business. To defer paying tax on the gain from the sale of the farm, Fred must buy some other type of investment real estate. It doesn't have to be a farm—it can be an office building, apartment building or any other kind of investment real estate. The place to start with this type of transaction is with the residence.

Any gain from the sale of the residence is effectively taken off the table and Fred won't ever have to pay tax on that gain again. Fred's smart and knows to always take the tax-free cash first. He should also allocate as much of the sales price as possible to the sale of the residence. He'll likely work with his Realtor and CPA to arrive at the price that allocates as much of the overall sales price as possible to the residence.

The price of the residence is then subtracted from the value of the whole property and the balance is the amount allocated to the farmland and outbuildings.

For example, if Fred is selling the entire property for $2 million, he might allocate $500,000 to the residence and the remaining $1.5 million to the farm and out-buildings.

I suggest that Fred have two sales contracts; one for the residence portion and one for the farm portion. There are a couple of good reasons for this.

The first is if you only have one contract for everything and allocate the sales price on your tax return, the IRS can re-allocate the values if they audit you. Obviously they will only do this if it would result in more tax revenue for them, which is not good news for Fred if he doesn't have two contracts. But having two contracts prevents them from arbitrarily reallocating the values he uses. It also builds a firewall in his tax return: if they audit his exchange they won't automatically audit the allocation of value to the house.

And lastly, having two contracts obviously means that you have the buyer's agreement on your allocations; this is a key factor in preventing the IRS from reallocating the values in either party's tax return.

Other common bifurcated transactions we see involve the sale of duplexes, or small multi-unit residential property where one of the units is the seller's residence. Similarly, the sale of a house with a home office that's reported on the seller's tax return is ripe for bifurcating, especially if the gain on the house exceeds the Section 121 exclusion.