1031 Exchanges and Vacation Properties: Deferring Taxes on the Sale of a Second Home

It may be possible to perform a like-kind exchange with a vacation home, so long as you’re willing to limit your personal use.

IRC Section 1031 allows property owners to defer taxes on the sale of property that is held for business or investment use. Section 121 allows for the exclusion of some taxes on the sale of property that is the owner’s main home. But what about property that is neither, like a second home or vacation property? Here are the things the IRS looks at when determining if a vacation property can qualify under Section 1031 and how to avoid running afoul of regulations.

When can a vacation home be used in a 1031 exchange?

A 1031 exchange involves, at minimum, two properties: a relinquished property (the one you sell) and a replacement property (the one you buy). An important requirement of Section 1031 is that both properties must be held as investments or for use in a productive trade or business.

Establishing business use for the relinquished property is relatively straightforward for properties like retail stores or warehouses that are vital for the operation of a business. It’s unlikely your vacation home would qualify in that regard, but it could qualify as a rental property even if it isn’t rented out for the entire year. For example, if you list your vacation home on a short-term rental site like Vrbo or Airbnb for the dates you’re not using it, that would be considered business use.

It’s a bad idea to think you can outsmart the IRS on this point. You can’t just list the property for one day a year while using it the rest of the time, list it at an astronomical price to avoid having to deal with actually renting it out, or list it as a rental for only a month before selling it. The business use must be legitimate and must supersede your personal use.

Because there are so many scenarios that could come into play, there has never been a hard and fast rule telling exchangers exactly what they must do to turn a second home into a business. To alleviate confusion, the IRS issued Rev. Proc. 2008-16, which provides “Safe Harbor” guidelines. These guidelines don’t cover every scenario that might be allowed, but so long as your exchange fits within these parameters, you can be relatively certain it will meet the agency’s approval.

The Safe Harbor guidelines state that “in each of the two 12-month periods immediately preceding the exchange,” the exchanger must rent the property at fair market value for at least 14 days. The phrase “fair market value” is important, because it prevents property owners from “renting” to friends and family without actually charging them.

The exchanger’s personal use must not exceed “the greater of 14 days or 10 percent of the number of days” it is rented during a 12-month period. If your vacation home is only rented for the minimum 14 days in a year, then you can’t use it for more than 14 days yourself. If it is rented for 200 days out of the year, you could use it for 20 days without violating the guidelines.

When asked at a JTC webinar about proving that a home was rented for the requisite number of days (and not employed for personal use more than the limit), Head of Specialty Administration & General Counsel USA Jill Jones had this to say:

“If you do have a situation where you have a vacation rental and you’re using it part of the time for personal use, the number-one important thing for you to do is document, document, document,” she said. The more evidence you can provide, such as marketing materials for the property, receipts, or proof of rental income, the easier it will be to demonstrate business use.

Establishing business use isn’t just for the relinquished property. You must also show that the replacement property is being held for business use. The same rules apply to the relinquished and replacement properties as far as how many days the dwelling must be rented out and how many days it can be employed for personal use.

One mistake exchangers often make is thinking that once their tax returns have been processed, the exchange is safe. But this isn’t true: if you exchange into a property that you claim is a rental property and then use it only for personal use, the exchange could be invalidated after the fact, leaving you with a considerable tax burden.

Can I turn a vacation home into a 1031 property?

One of the most common questions we get regarding 1031 exchanges is how long does a property have to be held before an exchange? Like with so many things related to Section 1031, there is no hard and fast rule. If you have held a property for only a few months, it’s usually unwise to perform an exchange so soon, but if you can demonstrate that the offer you received was too good to pass up, it may still be allowed.

As for vacation properties, under the Safe Harbor guidelines, the exchanger must hold the relinquished property for two years prior to the exchange. If you’ve held your property for less than two years, you may need additional documentation to prove that it was not held primarily for sale and was indeed a legitimate investment property.

But what if this isn’t a property you’re acquiring now, but one you’ve held and used as a second home for many years? It is possible to convert a property held as a vacation home into a 1031-eligible property. By establishing business use according to the Safe Harbor guidelines, your property can qualify even if it was previously held only for personal use.

How long should you use the property in this way before selling? Based on the Safe Harbor guidelines, many professionals would recommend holding it for business purposes for two years, but that doesn’t mean there is a strict requirement for you to do so. While each case is different, the longer you rent the property, the easier it will be to prove it was indeed used for business purposes.

Does a vacation home qualify for a 1031 exchange if I eventually make it my primary residence?

Many property owners look to downsize as they reach retirement age. They sell their primary residences and move to their vacation homes to live out their golden years. But if the property was acquired in a 1031 exchange, will doing so invalidate their tax deferral?

Generally speaking, your exchange should still be valid even if you later make the property your primary residence. Following Safe Harbor rules and renting the property for at least two years before moving into it can demonstrate that even if it eventually became your primary residence, it was initially acquired as a business property.

Once the owner has made the property their main home, another 1031 exchange isn’t an option. When the property is sold or inherited, it could qualify partially for Section 1031 and partially for Section 121 based on how it was used. The calculations would vary for each individual property, but the important thing to understand is that once you make the property your main home, it can’t be exchanged for a new investment property.

The best way to ensure a successful 1031 exchange

There are a lot of variables when it comes to 1031 exchanges, and each exchange is different, which is why it’s hard for the IRS to produce definite rules when it comes to situations like vacation homes used for business. There are other rules that also must be considered when converting a personal property to a 1031 property or a 1031 property to a main home.

For example, your vacation home and your current residence may be in different states, or even in different countries. State-to-state exchanges and foreign property exchanges are permissible, but must follow the guidelines for those types of exchanges (for example, you can’t exchange a U.S. property for a foreign property). You must also follow local laws, and doing so requires understanding the laws for the country, state, or territory where each property is located.

To perform a 1031 exchange, you need a Qualified Intermediary (QI) to hold funds during the exchange. Working with a QI that doesn’t understand the rules of the districts where your properties are can lead to mistakes that might jeopardize your exchange. To give yourself the best chance at full tax deferral, you should work with a QI that follows 1031 exchange best practices for handling exchange funds, providing transparency, and complying with all local, state, and federal regulations.