Using 1031 Exchanges for Vacation and Second Homes

Section 1031 of the Internal Revenue Code allows taxpayers to indefinitely defer gain on the sale of real estate held for business or investment purposes. As a general rule, this means that Section 1031 does not apply to personal residences (although there is a separate federal tax exemption for capital gains from the sale of a primary residence). But what about second homes and vacation homes? These real estate assets often fall somewhere in the middle, and this makes it critical to work with a 1031 exchange expert who can help you achieve maximum tax savings while remaining in full compliance with the law.

1031 Exchanges Involving Vacation and Second Homes: An Overview

Vacation homes and second homes can qualify for like-kind exchange treatment under Section 1031 in some circumstances. To defer taxable gain on the sale of a vacation home or second home, the owner (or owners) must meet various requirements established by the Internal Revenue Service (IRS) and the federal courts. Meeting all of these requirements is critical, as failing to satisfy even one of them can render a vacation property or second home ineligible for a tax-deferred 1031 exchange.

Here are the main requirements that apply:

1. At Least Two Years of Ownership

To qualify for a like-kind exchange under Section 1031, a vacation home or second home must be owned for at least 24 months prior to the date of the exchange. This is a hard-and-fast rule. Thus, the timeline for qualifying under Section 1031 is twice as long as the timeline for qualifying for capital gains treatment in a taxable disposition.

2. Rental for At Least 14 Days Per Year

For at least two years of ownership, the owner (or owners) must rent the vacation home or second home for at least 14 days each year. The property must be rented for fair market value for these 28 days.

3. Limited Personal Use

During the first two years of ownership, the owner (or owners) must not make personal use of the property for more than 14 days or 10 percent of the days that the property is rented. This requirement also applies annually. However, if an owner is working on remodeling or repairing the property, then any days spent at the property making updates or repairs do not count toward this limited “personal use” period.

To be clear, these requirements only apply to two years of ownership. After you meet these requirements for two years, you are not required to maintain any minimum rental occupancy or limit your personal use of a vacation property or second home that you intend to relinquish in a like-kind exchange.

The Rules for Vacation and Second Homes Apply to Both Properties in a 1031 Exchange

When you plan to sell a vacation property or second home in order to buy another, the rules we just discussed apply to both properties involved in your like-kind exchange. However, with respect to the replacement property, the rules apply during the first two years of ownership. The IRS makes this clear, stating that the rules apply during the “24 months immediately after the exchange.”

Even so, taxpayers can still claim tax deferral under Section 1031 immediately. As the IRS goes on to explain:

“If a taxpayer files a federal income tax return and reports a transaction as an exchange under § 1031, based on the expectation that a dwelling unit will meet the qualifying use standards . . . and subsequently determines that the dwelling unit does not meet the qualifying use standards, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange under § 1031.”

An experienced 1031 exchange expert will be able to assist with gathering and generating the documentation you need to prove that your exchange qualifies for tax deferral under Section 1031. While the IRS might never scrutinize your exchange, it will be important to have this documentation on hand to confirm your eligibility to conduct a 1031 exchange and to withstand scrutiny from the IRS during an audit if necessary.

Speak with a 1031 Exchange Expert at 1031 National Services for Free

If you would like more information about conducting a 1031 exchange involving a vacation property or second home, we invite you to get in touch. To schedule a free, no-obligation consultation with a 1031 exchange expert at 1031 National Services, please call 888-872-1031 or tell us how we can help online today.