Does Your Vacation Home Qualify for a 1031 Exchange? Here’s What Tax Code Says

by | BiggerPockets.com

When work relocated our family from sunny Denver to the Northeast, we transitioned most of our real estate holdings near our new home without paying capital gains tax using 1031 exchanges. But our favorite exchange was the purchase of a vacation home in Florida. Absentee ownership of a short-term rental has its unique challenges, but no other investment property we have owned has come close to generating as much fun and great family memories.

How can you tell if your vacation home will qualify for a 1031 exchange? 1031 exchange tax code reads:

“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”

What does this mean for your vacation home? Read on, BiggerPockets Nation! Here’s what you need to know when it comes to vacation homes and 1031 exchanges.

What’s Your Intent?

Intent matters. The intent with which you purchase and use your property is very significant when you are trying to determine whether or not your vacation home is eligible for a 1031 exchange. Over the years, the IRS has clarified that property would not qualify for a 1031 exchange if it is determined that the owner utilized it primarily for personal use. If the real estate is to qualify, it must be a property used for productive business, trade, and investment purposes.

Related: How Much Should You Be Paying for a 1031 Exchange? [New Research!]

The code is nuanced in that it focuses on your primary intent as borne out by your actions. For example, in the 2007 case of Moore v. Commissioner of Internal Tax Revenue, the Moores claimed to have held a vacation home for investment (solely appreciation) purposes. Ultimately, they were unable to prove the claim. They used it primarily for personal reasons and stayed at the home frequently. Therefore, the home was ineligible for a 1031 exchange.

vacation-seasonal

 

Safe Harbor Rules

Safe harbor rules can provide some clarification when it comes to vacation homes and 1031 eligibility. In 2008, the IRS added this provision to the initial tax code. It specifies that so long as the provision has been adhered to, the IRS “will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment for purposes of § 1031 of the Internal Revenue Code.” But these rules are not meant to be prescriptive and required. Rather they serve as a recommendation specific only to the particular fact set described in the rules.

Using these rules as guidelines, you can establish whether or not your current vacation property qualifies in a manner that will not be challenged. These rules are:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the “qualifying use period”)

(b)  Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,

(i)  The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and

(ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental. For this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).

These rules give investors one basis for creating 1031 exchange eligible vacation property.

Before purchasing a home with exchange funds or with the intent to exchange it, confirm that your intended use meets the IRS requirements for the exchange. The criteria for replacement properties are similar.

For professional guidance, you should seek out a 1031 qualified intermediary (QI) and your tax advisor. Note that an expert who works specifically on 1031 exchanges may prove to be your best initial consult on the matter.

Related: The 1031 Exchange Ultimate Guide for Real Estate Investors

Is My Vacation Home Eligible?

The IRS developed the safe harbor provisions to provide guidance, but they are not the only criteria used. Tax rules are interpreted via case law. These interpretations vary from situation to situation. Therefore, you should consider these aspects of qualifying for a 1031 exchange:

  • Personal use: If you allow friends, family, and even strangers to use your property without charging them, you may still qualify. Keep records of your personal use of the property.
  • Use while conducting repairs and renovations: Time spent at your property to conduct repairs and renovations may be outside of the personal use limits established in the Safe Harbor provisions. Keep records of working visits such as these.
  • Not generating rent: Renting your vacation home is not the only way to qualify its productive use in business, trade, or investment. Some investors purchase vacation homes simply to hold for appreciation. Carefully document personal to substantiate the claim of investment versus personal dwelling.
  • Tax law on a case-by-case basis: There have been situations where a 1031 exchange should have been possible, but wasn’t, and vice versa. The best way to get a definite answer in your particular situation is to do your research by consulting with an experienced QI and your tax professional.

Conclusion

When transitioning into a vacation home, it is important to establish investment intent. The safe harbor provisions provide useful guidance regarding the 1031 exchange eligibility of vacation properties. However, other factors can be taken into consideration and impact qualification. The bottom line is that if you purchase or sell a vacation home using a 1031 exchange, then you must demonstrate its use for business, trade, or investment purposes. Your intent is key—but with a vacation home, it is possible to intentionally combine business with pleasure.

References

Legal Information Institute. “26 U.S. Code § 1031—Exchange of real property held for productive use or investment US Code.” Accessed 30 November 2018.

United States Tax Court. “T.C. Memo. 2007-134.” Accessed 30 November 2018.

Internal Revenue Service. “Rev. Proc. 2008-16.” Accessed 30 November 2018.

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About Author

Dave Foster

Dave Foster, real estate investor and qualified intermediary, has 20 years of experience working in all phases of real estate investing, from large scale development to single family homes and vacation rentals. This experience has given him a keen eye for opportunity and a clear vision for reducing the impact of taxes. A degreed accountant with a Master’s in management, Dave is Regional Director for Exchange Resource Group and has recently launched his own educational website, The 1031 Investor. Dave has built his reputation on being a driven, results-oriented 1031 Exchange Qualified Intermediary who works relentlessly to maximize value for the real estate investors he works with. He has taught numerous certified continuing educations courses on investment tax strategies. His particular focus on basic and advanced 1031 exchange topics has made him a popular guest speaker for local realtor associations, investment clubs, and podcasts. He teaches agents, investors, and advisors alike the ins and outs of 1031 exchanges and other tax and investment options.

2 Comments

  1. David Fisher

    You can defer the capital gains tax, state tax, depreciation recapture and the Obamacare tax on a vacation property even if it is used strictly for personal enjoyment and not any type of investment using a program based on Section 453. If you want to transact a 1031, do it but you can defer taxes without a 1031 if you choose to do so.

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