Second home vs investment property and 1031 exchange

9 Replies

Hello,

I bought a condo (paid cash) near the bottom in 2010 and its current market value is quite good. My parents have been staying there rent-free but they have a new place and so we want to consider doing a 1031 exchange. Can I do 1031 exchange without renting it out first? If I rent it out, how long should I do it (i.e. IRS tax filing as a rental)? Is 1 year enough? Thanks for any guidance.

If you've lived there 2 out of the past 5 years or have some proof of that, why  not sell and get a tax free gain. Screw the 1031 if you can.

@Son N. , Without documentation that the property has been held for investment it would not qualify for 1031 treatment.  Your parents have been living there but in order to qualify for sec 121 it must be your primary residence so screw the 121 it won't qualify and you'll end up really screwed :)  

There is a safe harbor in Rev Proc 2008-16 that establishes 2 years as adequate.  However there's a ton of folks out there that feel and act that anything over one year is fine (reported on two tax returns).

you may want to think about setting it up as a rental for your parents.  Actually do a lease and charge, collect, and report market rent.  You can always use legal means to gift back that rent to them while at the same time establishing the property as investment without displacing them.

Hi,

Thanks for the info. I'd like to clarify:  I don't/won't live there so I know I cannot use sec 121 exclusion and that's fine. Also, my parents now have a new place/property and won't live at this condo. I want/plan to use 1031, maybe not right away but after renting it out for a while. My question is about the "a while" part. How long should rent it out (i.e. convert a second home into a rental prop) before 1031 applies/works?

Thanks 

@Dave Foster - "Without documentation that the property has been held for investment" - Can you share what documentation do I need for this purpose? Thanks

@Son N. , an actual rentor in with a lease agreement is great documentation.

Email conversations with your professionals strategizing on how to treat this property long term is also documentation.

Getting the property on your Schedule E is pretty important as well.

All of these things paint a picture.  There's no statutory time period that you must hold the property after your parents move out.  But your intent must be perceived to be holding for productive use.

Most folks feel comfortable with anything more than a year as that puts your rental property on two consecutive tax returns.  But there could always been circumstances where a shorter or longer hold period might be appropriate.

Thanks for the additional info. How does something qualify as an investment vs. a rental? 

Rental is easy. As for investment property, there is no renter/lease or schedule E. 

As for this one, we knew buying it at such a low price, it would go up in price, by how much, we did not know exactly but we knew there will be some. It was considered an investment in my mind. But how does something qualify as an investment property in the eye of IRS for 1031 purpose?

Thanks in advance

@Son N. , welcome to the murky world of 1031.  There's no regulatory definition on the meaning of "investment" vs rental or holding period.  There is an assumption born out in case law that "productive use in trade business or investment" implies a longer period of time.  But more importantly the bright line test appears to be the "intent' of the tax payer.

If your intent was primarily to resell (most interpret that as a forced appreciation/value add/low ball purchase scenario where the desired equity is present at the time of purchase) then you are treating the property as inventory and 1031 is not appropriate.

If your intent was to hold to use or to generate income from, or to take advantage of longer term appreciation then you are treating it as an investment and 1031 is appropriate.  And you're absolutely right rental on schedule E is so much easier to use to demonstrate intent.

Your biggest challenge is the fact that putting your parents in there is very easy to interpret motives not investment making it personal property and not investment property.  To simply vacate that and then sell it would probably not pass a field agent's sniff test.

Far better to put a rentor or leave your parents in there but treat them as rentors for another year or so.  Then sell and 1031 with plenty of evidence on your tax returns as to your investment intent.

Thanks Dave!

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