Can I Do a 1031 Exchange on a Second or Vacation Home?

Section 1031 exchange provisions apply only to property held for investment or for use in a trade or business. So, the short answer is no: held as your vacation home, it doesn’t qualify. It’s not qualified investment property as required under Section 1031 (study it at Cornell Law School’s website), which reading in part:

No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment. [emphasis added]

Held for investment involves holding property for future appreciation. Used in a trade or business entails income producing, e.g. use in a business or as a rental property. The controlling question is:

Was it your intent to hold the property for investment or use in a trade or business?

Undeniably your intent for holding real property may change. The challenge then is convincing a skeptical IRS that changes aren’t simply a 1031 Exchange vacation home tax avoidance ploy. And in any event, it usually can’t be done within weeks or months without risking an audit.

For many decades, speculation abounded over exactly what was required to show a change in intent. Claiming a change in investment intent, experts postulated: what if you had:

1. rented the home out at fair market value and only occasionally stayed there,
2. decided to convert your vacation home into rental property altogether, or
3. sustained a financial setback causing a change in intent.

Regarding Issue #3, an unforeseen hardship may have a silver lining, financially at least. In Reesink v. Commissioner, Tax Court Memo 2012-118 (April 23, 2012) the taxpayer had already exchanged investment property. With his replacement property, he had:

• placed rental flyers citywide advertising the house as available for rent,
• showed the house to two different potential tenants,
• refrained from using the property for recreational use,
• decided to sell their personal residence almost six months after purchasing this replacement property, and
• waited over eight months after acquiring the property to move in.

Then Reesink sold the families’ primary residence out of financial concerns. He had experienced a loss of income due to illness. There was a cash flow issue with expenses associated with two rental properties plus his primary residence.

Under these circumstances the exchange was approved by the IRS Commissioner. The key point is unpredictable events can legitimately interrupt one’s original intent for holding property.

With respect to Issues #1 and #2, fortunately those decades old uncertainties began unwinding in 2007. The Department of the Treasury’s Inspector General issued a report entitled Like-Kind Exchanges Require Oversight to Ensure Taxpayer Compliance. The report called for the IRS to provide more 1031 Exchanges oversight. The Report’s Impact on the Taxpayer statement reads:

The practice of deferring capital gains tax through like-kind exchanges is increasing in popularity. However, if taxpayers do not specifically follow the rules for like-kind exchanges, they could be held liable for taxes, penalties, and interest on their transactions. Therefore, it is important for the IRS to provide specific and consistent guidance to taxpayers on this provision of the tax law. [emphasis added]

Long overdue, the IRS responded the following year by issuing Revenue Procedure 2008-16. It provided a pathway for completing 1031 Exchanges by promulgated specific safe harbor guidelines. With full compliance, your vacation home could be exchanged in time substantially risk-free.

Now at last you could confidently move forward on a like kind exchange vacation home albeit a two-year process. While a faster route isn’t necessarily precluded, you may be satisfied with adhering to these guidelines.

The following safe harbor guidelines forestall challenges on audit.

• You must own the home for at least 24 months (called Qualifying Use Period) prior to the 1031 Exchange.
• Within the Qualifying Use Period, in each of the two years, you must rent out the home for 14 days or more at fair market rental value.
• You cannot use the home 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.

Some latitude in observing these rules is allowed if your actions are supportable.

• Time spent making repairs and improvements, e.g. could be left out of the personal use count.
• Likewise, family members paying you fair market rental rates for the home as their primary residence doesn’t qualify as personal use.
• Fair market rates are based upon existing factors when the agreement was entered.
• Rental agreement rights and obligations are subject to review, i.e. whether they meet arms-length standards.

Now safe harbor guidance provides you with a risk-free, two-year 1031 Exchange path to:

• rent the home out at fair market value and only occasionally stay there or
• convert your vacation home into rental property altogether.

Can’t or don’t want to wait two years? Successful exchanges can be completed under two years but with attending risk. The central issue is demonstrating investment intent for holding the property being exchanged.

Again, it’s undeniably that intent for holding a vacation home can change. We change our minds all the time. The goal is to establish viable facts and circumstances capable of fending off any IRS claim of tax avoidance motivations.

That can only be done with convincing evidence. Every potential exchange is unique and rests on its own merit. Say you no longer use your vacation home and are thinking about an exchange.

This is a pivotal point where you should be setting in motion actions showing an intent to hold property change. Proactive planning positions your property for success in a tax-deferred exchange.

Actions that buttress your claim to investment intent include:

• keeping the property rented, not merely offered for rent,
• keeping the personal use days–if any–to less than 14 days a year,
• limiting uncounted maintenance days to a reasonable number,
• filing year-end rental Schedule E income and expenses schedule,
• depreciating your rental,
• retaining a cleaning service between renters, and
• consider a separate bank account for this property.

Facts, circumstances, and timing will be key. The more time that property remains a rental the better. While there’s no set lapse-time, anything less than a bona fide six-months rental period is likely to raise an IRS red flag. A year would be better.

Not exhaustive, activities such as these will make it difficult for any IRS challenge to prevail.

Details matter to the IRS and the Courts in contested exchanges. Take the aforementioned Reesink case. One might think that financial stress was the most persuasive taxpayer argument.

Not so said the IRS Commissioner’s findings that read in part:

Perhaps the strongest indicator of petitioners’ intent at the time of the exchange comes from respondent’s witness — Michael Reesink. He testified that Mr. Reesink had told him on several occasions that petitioners planned to sell their personal residence and move to Guerneville once their children were out of high school. … at all times during the exchange process petitioners’ eldest son was only 14 years old. Moreover, he was only 15 years old when petitioners moved into the Laurel lane property — he was still in high school throughout all of the events surrounding the like-kind exchange. Michael Reesink’s testimony supports the proposition that at the time of the exchange, petitioners held the Laurel Lane property with investment intent. [emphasis added]

Minutia cuts both ways. It paid off in the Reesink case by recounting what might have been considered trivial events. Conversely, seemingly minor acts of commission and omission could sabotage your exchange. Discovering belatedly, e.g. that a HOA covenant prohibits rentals when a successful exchange requires it.

So, if you conduct yourself in an investor-like manner and keep your property rented, your exchange is likely to succeed. You’re now holding a home with investment intent.

It may qualify:

• immediately if your property has been rented out for some time already,
• after it’s been rented out for at least six months (ideally for one year), or
• after two years following safe harbor guidelines.

Safe harbor provisions provide risk-free eligibility guidelines. Not that there aren’t many other hurdles to clear in a 1031 Exchange. You can combine business with pleasure, albeit within that 14-day personal use limit.

Also, there’s ways to a successful exchange without safe harbor guidance. Close calls regarding eligibility and other issues may emerge. Expertise is required on your part or that of your tax advisor to optimize financial gain.

Note: regulations for doing a 1031 exchange on your second home are very similar to exchanging a primary residence. But in case you want to learn more about it, we have two guides on this subject too:

• How Can You Do a 1031 Exchange on a Primary Residence?
• How to Do a 1031 Exchange from a Rental Property to a Primary Residence

Yes, but you can’t start with buying a rental property expressly to exchange it for a vacation home. Then there are two Qualified Use Periods to satisfy here, i.e. for the relinquished (rental) and replacement (to be vacation home) properties. And yes, the logic gets stretched here. You’ll be searching for suitable vacation property but initially your intent is holding it as an investment.

Again, the IRS affords safe harbor guidelines under the same Rev. Proc. 2008-16 issuance. Replacement property rules are similar to the relinquished property rules just covered. You’ll have limited personal use of the property, i.e. up to 14 days annually for the first two years.

When purchasing replacement property with safe-harbor protection, you must:

• own the vacation rental for at least 24 months (Qualifying Use Period) immediately following the close of the Exchange,
• within the Qualified Use Period, in each of the two, 12-month periods, rent out the investment property for 14 days or more to another person at fair market value, and
• 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.

With adherence to all other 1031 rules, your exchange is assured. At the end of the two-year safe-harbor holding period, you can convert the property to personal use as a vacation home.

Note that under these safe harbor guidelines, completion of this exchange takes place within a four-year window. Both the relinquished and replacement properties must be held for productive use in a trade or business or for investment for two years.

Again, these guidelines are not mandatory rules. It’s possible to only rent the home out to tenants for six months or a year before selling (relinquishing) it. It’s also possible to only rent your replacement for less than two years before moving in as the Reesinks’ did.

Once again, each exchange is unique with its own set of facts and circumstances. You’ll need to be prepared to support investment intent, particularly if either property is held for less than one year.

Here’s how not to proceed! In Goolsby v. Commissioner, Tax Court Memo 2010-64 the taxpayers exchanged two rental properties. The taxpayers’ actions related to the replacement to be vacation home were a prescription for exchange failure.

• Their efforts to rent the property were minimal.
• In less than two months, Goolsby and his family moved into the property.
• No research had been done to determine whether homeowner’s association (HOA) covenants might prohibit rentals.
• Nor had they researched rental opportunities in the area prior to the exchange.
• Renovation of the basement was started within two weeks of purchase.

No surprise, the transaction failed to receive Section 1031 treatment. The Court found no intent to hold property for productive business use or investment purposes.

Here’s what the pros call for in preparing for a successful exchange: Take good faith actions in keeping with that of legitimate investors. What would they do in given situations? Conversely, avoid actions atypical of seasoned investors. This may mean engaging a tax advisor with relevant experience to map out a detailed plan.

There are some common sense actions to take related to a 1031 Exchange for a to be vacation home.

• Keep detailed records of personal use/maintenance days and other relevant activity.
• Avoid any premature disclosure of any plans to move into the property.
• Wait several months at least before taking preparatory action for moving in.
• Be patient about occupying the rental post-exchange, ideally wait at least a year.
• Document concerted efforts to rent out the property with postings, listings and other advertising.
• Document how you calculated the rental charge at the fair market value.
• Establish whether any covenant or other property restriction might impede rentals.
• If an unforeseen event–job loss, illness, etc.–occurs, document how it caused a change in intent.

Again, outside safe harbor’s two years, there’s no prescribed waiting period before occupying your home. Original intentions may change at any time, particularly with an unforeseen event occurring. Of course, longer Qualified Use Periods likely makes it easier to establish intent.

Whatever the holding period is, don’t discount the need for due negligence. In Allegheny County Auto Mart v. C.I.R. 208 F2d 693 (1953) the Court accepted an exchange with relinquished property held just five days. Yet in Klarkowski v. Commissioner, TC Memo 1965-328–despite holding replacement property for six years–the Court disallowed the exchange based on other grounds.

Takeaway: Every 1031 Exchange requires substantiation regarding your intent for holding properties. That intent must be to hold the property for investment or use in a trade or business. It may take the form of utilizing the qualifying safe harbor route. Or you may elect another often-quicker approach that’s consistent with you:

• holding the property(ies) with investment intent and
• generally adhering to safe harbor guidelines except the two-year provision.

Carefully documented, this approach — while absent the safe harbor assurance — certainly deserves your consideration when planning a 1031 Exchange. Once again, this requires expertise on your part or that of your tax advisor.

Section 121 Primary Residence Capital Gains Tax Exclusion

You know this one, the $250,000 ($500,000 married) gains exclusion on the sale of your principal residence. To qualify for the principal residence exclusion, you must have owned and used the home as your primary residence for at least two of the five years before the sale.[1] The ownership/usage requirements may not need to be the same two years.

Exercising this exclusion is curtailed following 1031 Exchanges. We know a replacement (vacation home) can’t generally be converted into your primary home immediately. Under safe harbor guidelines, it’s two years. Otherwise, many experts recommend at least a one-year Qualified Use Period in most situations.

Before the law was changed in 2004, investors had been readily combining a 1031 exchange on second homes with 121 exclusions. Excessively so some felt, deferring gains on 1031 Exchanges then promptly following up with unlimited 121 exclusions.

Now 1031-acquired property sold as your principal residence carries a five-year waiting period before 121 exclusion applies. The count starts with the exchange date when the replacement property was acquired. So, you’ll have to wait a lot longer to fully utilize the primary-residence’s capital-gains tax break.

In a 1031 Exchange, the relinquished property’s sales price less its modified adjusted basis (minus selling expenses) is your realized gain. The 121 exclusion applies to 3/5ths but not the 2/5ths of the gain when rented out.[2] The exclusion also does not apply to the depreciation recapture.

For example, you acquired a replacement vacation rental with a $195,000 tax basis in a 1031 Exchange. After two years you converted it into your primary residence. When sold after five years, your realized capital gains of $100,000 with $10,000 of that gain representing depreciation recapture. We’ll have more on recapture in the next section.

Two-fifth of the $90,000 ($36,000) is subject to capital gain taxes for the two years of non-qualified 121 use as a rental. This assumes adherence to safe harbor guideline’s two-year Qualified Use Period as a rental.

For federal tax purposes, with a single filer’s Modified Adjusted Gross Income (MAGI) less than $200,000 but more than $40,000, the capital gain tax rate is 15%. On that basis, tax due is $5,400 on capital gains. Then you’ll qualify as the primary resident for the 121-tax exclusion on the remaining three-fifth of the capital gains.

[1] Exceptions to the 121-tax exclusion limitation apply to active military personnel required to relocate. Also, this exclusion may be utilized once every two years.

[2] Any addition to the Qualified Use Period after living in the property is considered in calculating the exclusion amount. Say you complete a 1031 Exchange; rent out the property for two years; occupy it for three; and then rent it for another year before selling. You’re allowed four years of ownership toward the primary residence exclusion.

Depreciation Recapture

The primary residence exclusion only applies to capital gains, not depreciation recapture. This recapture tax is imposed on rental property depreciation that you’ve previously expensed (or should have deducted). Recall the earlier advice to depreciate your rental on Schedule E.

When that property is sold for more than its depreciated value, a recapture tax of up to 25% applies to the amount of depreciation previously expensed.

Replacement rental property received in a 1031 Exchange is usually depreciated over 39 years. In the previous example with a $195,000 tax basis, accumulated depreciation was $5,000 annually.

Over the 2-year Qualified Use Period as a rental, the future vacation home accumulated $10,000 in depreciation. It’s expensed over two years on your annual tax return. Now being recaptured, it’s taxed at 25% or $2,500 in ordinary income.

A 1031 Exchange can be rewarding in many ways but compliance with the Rules are daunting and time-consuming. Not just for business uses, it’s especially rewarding when qualifying exchanges add to your personal enjoyment. However, missteps can often be unforgiving, risking exchange failures altogether.

A reputable 1031 Exchange company with tax attorneys on their team will consult you and your tax advisor/CPA and guide you through each step of the 1031 Exchange process. Before the exchange, they will review your situation and advise on whether your plans satisfy the IRS requirements or need adjustments to perfectly comply with the rules.

HouseCashin is an all-in-one platform for residential real estate investors that maintains relationships with top-rated 1031 Exchange firms throughout the USA. To get connected with the best professionals and have your exchange processed safely and effectively, fill out the form below.