Are you looking to buy or sell a vacation home using a 1031 tax deferred exchange? The pros at 1031 Exchange Place are here to tell you that this is often possible, but whether or not it works for you will depend on a few important factors.
In essence, the question comes down to this: Has the property been for personal use, or for investment purposes? Let’s go over the ins and outs that matter here.
Personal Use Basics and Definitions
To perform a 1031 exchange on a property, both properties – the relinquished one and the replacement – must be used for investment purposes, or for use in a trade or business. How does this work for vacation homes, which may have varying levels of use?
Essentially, this ends up speaking to whether any investment intentions were or will be carried out with the properties in question. Know that personal use extends not only to you as a taxpayer, but also to your family members, others with interest in the unit and their families, anyone using the unit while you live elsewhere (even if you don’t charge rent), or even anyone at all if you’re renting the property for less than fair market value.
One small trick here that allows you fully tax-free income on the home is renting a vacation home. You can do this for up to 14 days in a given calendar year without reporting any rental income whatsoever, and this also allows you a way to claim investment advancement. If you rent for more than 14 days in a year, you’ll have to report it.
Appreciation, Not Investment
While some taxpayers here have hoped to be approved for this kind of exchange by simply establishing the expectation of appreciation on the property, this generally isn’t enough. No attempt to rent, no deductions claimed for maintenance or depreciation, and other factors might show signs that don’t line up with investment intent.
IRS Safe Harbor
IRS Revenue Procedure 2008-16 provides what’s called safe harbor, meaning that the IRS will not challenge whether a property qualifies as an investment if the right procedures are followed using like-kind exchanges. There are ways to achieve these exchanges outside the safe harbor procedure, but you’ll generally be looked at more closely by the IRS. Requirements for meeting safe harbor are as follows:
- Meeting ownership requirements
- Limiting personal use of the property to whichever is greater – 14 days per year or 10 percent of the rental period
- Rental to an unrelated party for at least 14 days per year
- Treating the property as an investment – maintaining it, deducting maintenance and depreciation expenses, paying utilities and insurance, and more. For those with a mortgage on the property, ensure it’s an investment loan and not a primary residence mortgage – this will get you disqualified.
How Properties Qualify
The guidelines for both relinquished and replacement properties are as follows:
- All properties must have been owned by the investor for two years directly preceding the exchange.
- In each of the two consecutive years before the exchange, the investor must both rent the property for at least 14 days at fair market value and avoid using the property for personal use for either 14 days or 10 percent of the rental period, whichever is greater. Again, remember that personal use includes family members and other individuals, not just you.
For more on rules for exchanging vacation properties, or to learn about any of our 1031 exchange services or properties available, speak to the pros at 1031 Exchange Place today.