Vacation Homes and Tax Deferred 1031 Exchanges

By Edward E. Fernandez | August 28, 2023

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1031 Exchange for Vacation Homes

Some real estate investors consider selling their vacation home. However, selling this property may require you to pay high capital gains taxes. 1031 exchanges allow real estate investors to defer their capital gains taxes when selling their property and replacing it with another investment property.

Does your vacation or second home qualify? The Internal Revenue Service (IRS) has several regulations defining which properties qualify as vacation property for a home exchange. Understanding these rules allows you to exchange homes while gaining tax benefits.

1031 Vacation Home Rules

Since March 10, 2008, rules on exchanging vacation and second homes have become much clearer. The IRS created specific guidelines making it possible to efficiently 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, a vacation or second home must meet these safe harbor guidelines to qualify as the relinquished or replacement property in a 1031 exchange:

If your vacation property doesn't fall perfectly within the mold, discuss your circumstances with you legal and tax advisors. Your property may still be eligible for a tax-deferred 1031 exchange.

  • The subject property has been owned and held by the investor for at least 24 months immediately preceding the 1031 exchange, also called the qualifying use period.
  • 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.
  • The investor limited their personal use and enjoyment of the property to not more than 14 days during each of the preceding two years or 10% of the number of days that the subject property was actually rented out to other people during each of the preceding two years.

The safe harbor guidelines only apply to dwelling units. A dwelling unit is a real property with a housing structure — a house, apartment, or condominium — that furnishes basic living needs, such as cooking facilities, a bathroom, and a sleeping space.

Personal use of these properties includes using the property for any part of the day in these ways:

  • By you or another party with an ownership interest
  • By a member of your family or the family member of another party with an ownership interest
  • By anyone under an arrangement allowing you use of another property, regardless of rent
  • By anyone paying less than market rent

Too much personal use of the relinquished or replacement properties can disqualify the exchange from the safe harbor guidelines. In this scenario, the IRS can challenge the legitimacy of the tax-deferred 1031 exchange.

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. Nevertheless, your property may still be eligible property for a tax-deferred 1031 exchange. If your vacation property doesn’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 property in a tax-deferred 1031 exchange.

Benefits of 1031 Exchanges for Vacation Homes

A 1031 exchange for your vacation home offers many benefits:

  • Tax deferral: You can defer taxes by rolling over the capital gains from your vacation property to another investment property.
  • Improvement opportunities: If you stay at your vacation property to work on renovations, this time does not count against the 14-day limit.
  • Personal enjoyment of the property: You can eventually use your vacation property as often as you like after two years of personal stays that are 14 days or less and no more than 10% of the time you rent the property.

1031 Exchanges: Established for Efficiency

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? 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.

Background of Exchange Regulations

Here’s a history of exchange regulations for your reference:

  • 1981: The Private Letter Ruling 198103117 was issued by the IRS, indicating that properties that were, at least partially, used for investment or business purposes could be exchanged.
  • 1991: The Department of the Treasury issued the Deferred Exchange Regulations that indicated only properties held solely for investment or business could be exchanged.
  • 2007: The 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 its eligibility for a tax-deferred 1031 exchange without having to define the owner’s intent for the property.

1031 Exchange Vacation Home FAQs

Some common questions investors have about vacation home 1031 exchanges include:

  • Can I buy a vacation home with a 1031 exchange? You can invest the capital from a like-kind exchange into a vacation rental home.
  • Can I sell a vacation home through a 1031 exchange? As long as you follow the safe harbor guidelines, you can use a 1031 exchange to sell your vacation property.
  • If I use my vacation property, is it disqualified from a 1031 exchange? You must have limited personal use of your vacation property for it to qualify. The IRS rules are no more than 14 days per year and less than 10% of your rental time.

Learn More About Tax-Deferred Exchanges

Learn more about 1031 tax deductions

It’s possible to sell or acquire a vacation or second home through a tax-deferred exchange, though these opportunities are rare. The experts at 1031 Crowdfunding can help you navigate your unique circumstances to determine your property’s eligibility and ensure the exchange is compliant and thorough. Register with 1031 Crowdfunding today, or contact our team for more information..

 

This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.

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