Do you have a vacation or second home that doesn’t get used very often anymore? Have you considered replacing that home with something new?
If you’ve thought about selling that vacation or second home, have you wished you could sell it without having to pay high capital gain taxes? 1031 exchanges are popular among real estate investors to defer their capital gains taxes when selling their property, but does your vacation or second home qualify?
1031 VACATION HOME RULES
Since March 10, 2008, rules on exchanging vacation and second homes have become much clearer. The IRS created specific guidelines making it possible to efficiently complete a tax-deferred 1031 exchange of a vacation or second home for a replacement vacation or second home.
The guidelines, as seen in Revenue Procedure 2008-16, state a vacation or second home can qualify as the relinquished or replacement property in a 1031 exchange if:
The subject property has been owned and held by the investor for at least 24 months immediately preceding the 1031 Exchange (“qualifying use period”); and
The subject property was rented at fair market rental rates to other people for at least 14 days (or more) during each of the preceding two years; and The investor limited his or her personal use and enjoyment of the property to not more than 14 days during each of the preceding two years or ten percent of the number of days that the subject property was actually rented out to other people during each of the preceding two years.
While these guidelines help us understand how a vacation or second home can be considered an investment property to qualify under 1031 exchange regulations, some circumstances do not fall within these guidelines. Nevertheless, your property may still be eligible property for a tax-deferred 1031 exchange. So don’t miss an opportunity because you don’t fall perfectly within the mold, discuss your specific circumstances with your legal and tax advisors to see if your vacation or second home can qualify as an eligible relinquished property in a tax-deferred 1031 exchange.
MORE ABOUT 1031 EXCHANGES & VACATION RENTALS
Some property owners interested in completing a 1031 exchange of vacation or second homes may feel these guidelines restrict them from determining the use of the properties they own. The fact is that 1031 exchanges were established to make tax allowances for investors and business owners to do business more efficiently. But who says you shouldn’t be able to enjoy a property purchased as an investment? Before 2008 and the guidelines of Revenue Procedure 2008-16, it was hard to determine whether or not a property used as a vacation or second home could be exchanged at all.
Here’s a little history for your reference. In 1981 Private Letter Ruling 198103117 was issued by the Internal Revenue Service, indicating that properties that were, at least partially, used for investment or business purposes could be exchanged. Then in 1991, the Department of the Treasury issued the Deferred Exchange Regulations that indicated only properties held solely for investment or business could be exchanged. It wasn’t until 2007 when Tax Court Memorandum 2007-134 was filed and clarified that as long as the primary intent for the property was investment or business, the property could also have personal uses. The hard part was determining how to prove primary intent. Since the guidelines of Revenue Procedure 2008-16 were published, we now know for how long and how a property must be used to establish its eligibility for a tax-deferred 1031 exchange without having to define the owner’s intent for the property.
Depending on your circumstances, jumping through hoops to make your vacation or second home fall within these guidelines may or may not be worth it to you. But, at least you now know it’s possible to sell or acquire a vacation or second home through a tax-deferred exchange.