1031 Into a Vacation Rental?

Question

I own a highly appreciated SFR in AZ and am planning on selling once my current tenant's lease expires early next year. My thoughts are to 1031 the gains into a vacation rental (or possibly a full time rental). If I operate the property as a short term, "vrbo"  type, I'm guessing that there are specific rules about personal use? And how would that be tracked from an IRS perspective? I'm assuming that if the rental income reported isn't in line with "similar rental properties", I'd potentially be open to audit? Also considering that we are a couple years away from "retiring" to that area, how would the transaction work if we were then to move into the property? Certainly not trying to tug on Superman's cape, but would just like to more fully understand how that all would work. Thanks!

Rachel (Raquel) Hart · Answer

@Dave Foster thank you for the quick reply, I sent you a DM to continue the conversation!

Dave Foster · Answer

@Rachel (Raquel) Hart, it really all comes down to your intent.  One thing I like to tell people is that no one should own a second home.  You can purchase an investment property with a 2nd home loan.  And you can have an investment property like a short term rental that you use some for your personal use.  But think of it as an investment property that you use some.  And not a 2nd home that you rent some.  Treat it that way and you'll preserve your 1031 option.

There is a safe harbor in Rev proc 2008-16 but that is not the statutory requirement.  There is only the standard of your intent and how you can demonstrate that.  So the question becomes what was your intent in the first purchase?  did you purchase it intending to hold for productive use.  Or simply to resell.  If the first you would qualify for a 1031 but would want to be able to demonstrate your intent if ever asked.  If the second it would not qualify for a 1031.  The key is that you purchased the first property intending to use if for investment and then something causes you to change your intent.  So you 1031 into another property you also intend to hold for investment purposes.

The reason that 2nd home loans don't matter is that the normal underwriting requirements are that the subject property is at least ??? miles away from your primary residence.  And you agree to use if for personal use a couple weeks a year.  Neither of those restrict you from meeting the safe harbor requirements.

Rachel (Raquel) Hart · Answer

@Dave Foster How about if you buy a property as a second home to use as a short term rental, make some renovations, but then decide to sell it using a 1031 exchange to get another second home to use as a short term rental. Is that allowed? Would have the new property being purchased needed be an investment property instead of a second home?
Along the same lines, since I purchased the house as a second home and not as an investment property I am unsure if can qualify for a 1031 exchange.
Thank you!

Dave Foster · Answer

@Peter Padalino, There is very little correlation between actual income, days rented and days used personally.  There is no statutory minimum income that qualifies your property.  There is no statutory minimum days rented.  And there is no statutory requirement limiting your personal use.There is a safe harbor from the IRS in Rev proc 2008-16 at personal use of either 2 weeks a year, or 10% of the number of days it's rented not counting days you stay there while working on it.

The standard is your intent and how you demonstrate that intent to hold the vacation property for investment use.  Extremes are easy to see - If you don't rent it and don't try to rent it then it's probably not being held for investment.  If it's rented year round and you squeeze a couple weekends at last notice when you can then it's probably being held for investment.

There's a lot of middle ground grey.  The way you communicate with the IRS is through your tax returns.  And there is no mention of number of days rented on your tax return.  There is only income and expense netted out.   So I wouldn't worry about the move from SFR to STR.  Simply have a business model designed to show that property as investment.

Which leads us to @Jonn Vidals question - This kind of thing happens all the time.  The safe harbor of 2008-16 also addresses that with a 2 year hold.  There are a large number of folks who feel that anything more than a year is fine.  And even the definition of when it stops being a rental you visit and a residence you reside in is a fluid target.

There's a whole heap of folks in AZ and FL who bought vacation rentals with 1031s and then later converted them and moved in as their retirement homes.  An awesome late career strategy.  Especially when you couple that move with a sale of their old primary residence.  So they get a big chunk tax free and move into a house which remains tax deferred as long as they own it.

Jonn Vidal · Answer

Good question! that makes me wonder for how long does a replacement investment property have to remain that way after it being an Exchange until one could potentially fall in love with the investment and move into it or part of it?1

1031 Into a Vacation Rental?

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