In my last three blogs of this four part series, we went over the Benefits of a 1031 Exchange - Part I, Different Types of 1031 Exchanges - Part II, and The Middleman to Complete a Successful Exchange - Part III

In this last segment, I would like to elaborate on a 1031 Exchange question I’m asked often, “Can I complete a 1031 Exchange with a vacation home or second home?”

And the short answer is yes.

Here’s what you need to know about exchanging mixed-use vacation home.

In 1981, the IRS issued a Private Letter Ruling (PLR) stating that you could 1031 Exchange out of a vacation rental and into another investment property if it was held as an investment as well as personal enjoyment. 

In 1991, the Department of Treasury issued the Deferred Exchange Regulations that went against the IRS's PLR. It stated that an Exchange must be held for investment only and not as a second home or vacation rental with the ability to use it for personal use. 

During this time, it was extremely confusing determining if a vacation rental or second home would qualify for a 1031 Exchange. 

Finally, in 2008, the IRS issued a Revenue Procedure clarifying the guidelines for qualifying a vacation rental or second home for a successful 1031 Exchange.

IRS Guidelines for 1031 Exchange on Vacation Rental or Second Home

For the sale of the vacation rental or second home (relinquished property) in a 1031 Exchange:

• The vacation rental or second home must be owned by the taxpayer for at least 24 months prior to the Exchange (called Qualifying Use Period)

and 

• Within the Qualifying Use Period, in each of the two, 12 month periods, the taxpayer must rent out the investment for 14 days or more to another person at fair market rental value.
• The taxpayer cannot use it personally for more than 14 days or 10 percent of the number of days that it is rented out at fair market value, whichever is greater.

For the purchase of a vacation rental or second home (replacement property) in a 1031 Exchange:

• The vacation rental or second home must be owned by the taxpayer for at least 24 months following the close of the Exchange (called Qualifying Use Period)

and 

• Within the Qualifying Use Period, in each of the two, 12 month periods, the taxpayer must rent out the investment for 14 days or more to another person at fair market value and the taxpayer must not use it personally for more than the greater of 14 days or 10 percent of the number of days that it is rented out at fair market value.

Use by the taxpayer or any family members, unless they pay fair market value, is considered "personal use".   

Here's an Example

A taxpayer has a mixed-use vacation home that’s worth $1,000,000. The home has a tax basis of only $600,000 and no mortgage. If the taxpayer sold the home, they would report a $400,000 taxable gain ($1,000,000 minus $600,000) on Form 1040. Since the taxpayer is now over their Adjusted Gross Income (AGI), there are additional taxes owed as well.

However, if the taxpayer wants to acquire another vacation home, they can do a Section 1031 Exchange. If the taxpayer finds another home worth $1,100,000, they would swap their old vacation home (the relinquished property) for the new one (the replacement property) and throw in $100,000 cash to equalize the trade. As long as they have met the abovementioned guidelines for both properties, a tax-deferred Section 1031 Exchange is ok, and the taxpayer avoids any current income tax hit. 

How to Make this Exchange Work

The property needs to be mixed-use. A taxpayer cannot make a 1031 Exchange on a vacation home or second home that is strictly for personal purposes. However, taxpayers can certainly set themselves up for a sale in the future by renting the property out for enough days over the next 24 months to meet the relinquished property safe-harbor guidelines. 

In conclusion, the more you rent out the investment property at fair market value, the stronger your argument that the property is an investment and should qualify for a 1031 Exchange.

I hope this four part series on the ins-and-outs of the 1031 Exchange world is helpful and informative. If you have any questions or need any real estate assistance, please feel free to contact me at any time. I'm here to help make your real estate dreams happen.

Warmest Mahalo,
Kengo Ueno (R)

This article is for informational purposes only and is not intended to be a substitute for professional tax advice. Every taxpayer's situation is different and they should meet with their personal tax expert before entering into a 1031 Tax Deferred Exchange.

Kengo Ueno (R)

 
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