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Vacation Homes & Tax Deferred 1031 Exchanges

Do you have a vacation or second home that doesn’t get used very often anymore? Have you considered replacing that home with something new?

Or perhaps, have you considered converting the equity in that home into investment funds? If you’ve thought about selling that vacation or second home, have you wished you could sell it without having to pay high capital gain taxes? Maybe you don’t yet own a vacation or second home, but have considered investing in exchangeable real estate that will help you earn the funds to purchase a vacation or second home through a 1031 exchange?

Since March 10, 2008, rules on exchanging vacation and second homes have become much clearer. The IRS created specific guidelines making it possible to easily complete a tax-deferred 1031 exchange of a vacation or second home for a replacement vacation or second home.

The guidelines as seen in Revenue Procedure 2008-16, state a vacation or second home can qualify as the relinquished or replacement property in a 1031 exchange if:

  • The subject property has been owned and held by the investor for at least 24 months immediately preceding the 1031 Exchange ("qualifying use period"); and
  • The subject property was rented at fair market rental rates to other people for at least 14 days (or more) during each of the preceding two years; and
  • The investor limited his or her personal use and enjoyment of the property to not more than 14 days during each of the preceding two years, or ten percent of the number of days that the subject property was actually rented out to other people during each of the preceding two years.
  • While these guidelines help us understand how a vacation or second home can be considered an investment property to qualify under 1031 exchange regulations, some circumstances do not fall within these guidelines that may still qualify your vacation or second home as an eligible property for a tax-deferred 1031 exchange. Don’t miss an opportunity because you don’t fall perfectly within the mold, discuss your specific circumstances with your legal and tax advisors to see if your vacation or second home can qualify as an eligible relinquished or replacement property in a tax-deferred 1031 exchange.

    Some property owners interested in completing a 1031 exchange of vacation or second homes may feel these guidelines restrict them from determining the use of the properties they own. The fact is that 1031 exchanges were established to make tax allowances for investors and business owners to do business more efficiently. But who says you shouldn’t be able to enjoy a property purchased as an investment? We now know that personal property has to be converted into property that is also used for investment or business to qualify as an exchangeable property. Before 2008 and the guidelines of Revenue Procedure 2008-16, it was hard to determine whether or not a property used as a vacation or second home could be exchanged at all.

    Here’s a little history for your reference. In 1981 Private Letter Ruling 198103117 was issued by the Internal Revenue Service, indicating that properties that were, at least partially, used for investment or business purposes could be exchanged. Then in 1991, the Department of the Treasury issued the Deferred Exchange Regulations that indicated only properties held solely for investment or business could be exchanged. It wasn’t until 2007 when Tax Court Memorandum 2007-134 was filed and clarified that as long as the primary intent for the property was investment or business, the property could also have personal uses. The hard part was determining how to prove primary intent. Since the guidelines of Revenue Procedure 2008-16 were published, we now know for how long and how a property must be used to establish it’s eligibility for a tax-deferred 1031 exchange without having to define the owner’s intent for the property.

    Depending on your circumstances, jumping through hoops to make your vacation or second home fall within these guidelines may or may not be worth it to you. At least you now know it’s possible to sell or acquire a vacation or second home through a tax-deferred exchange.

    While the information provided above has been researched and is thought to be reasonable and accurate, 1031 Crowdfunding are not lawyers or tax professionals. It’s important to consult with a licensed tax professional regarding your personal tax situation.

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