If you’re selling your vacation home or residence, you may wonder if you can defer taxes by using a 1031 Exchange. IRS rules limit the use of a 1031 exchange when real estate is held for personal use. Nevertheless, there are some circumstances when a 1031 exchange may be utilized with your vacation home or residence. Following is a look at a few of the most common.
Using a Personal Residence for a 1031 Exchange
When selling your primary residence, IRS Code Section 121 excludes gains of up to $500,000 for married taxpayers filing jointly or $250,000 for single taxpayers. To qualify, you must have used the property as your primary residence in two of the prior five years. In many cases, this exclusion is sufficient, and taxpayers do not have to worry about a 1031 exchange.
However, if your gain is greater than this exclusion amount and you meet the requirements, you may be able to shelter the balance by completing a 1031 exchange. The first step is converting a primary residence into an exchange-eligible property by meeting the following requirements:
- You must have owned the property for two years prior to the sale.
- In each of those years, the property must have been rented for at least 14 days.
- Your personal use must be limited to the greater of 14 days per year or 10% of the days per year that the property is rented.
It’s also important to note that the IRS does not disqualify a property if a family member was the tenant, as long as that individual paid fair market value rent and it was their primary residence, rather than a vacation home. If the family member co-owns the property, additional rules apply.
Converting a 1031 Exchange Property to a Personal Residence
Your sunbelt waterfront rental condo purchased as an investment may become your retirement home. Based on the facts and circumstances at the time of acquisition, according to IRS rules, if you purchased a 1031 exchange property with the intent to hold it as an investment or for business use, subsequent conversion of the property into your primary residence should not disqualify your exchange. However, special holding period rules apply. You may also need to allocate your gain between the periods the property was an investment versus a residence.
Rules Regarding Vacation Homes for a 1031 Exchange
It wasn’t always clear whether a rental vacation property sometimes used for personal purposes could qualify for a 1031 exchange. The IRS codified a safe harbor with the release of Revenue Procedure 2008-16. The safe harbor clarified the conditions under which a property would be considered “held for productive use in a trade or business or for investment” and thus eligible for a 1031 exchange. The safe harbor provided additional requirements:
- The taxpayer must own the property;
- The property must have been held as an investment for at least 24 months immediately prior to the exchange;
- The property must have been rented at fair market value for at least 14 days or more in each of the two 12-month periods before the sale, and
- The property must not have been used for personal purposes for more than 14 days or 10% of the number of days (whichever is greater) during each of the two 12-month periods that the property had been rented.
When a vacation home is used as a replacement property, the rules are essentially the same, except that the taxpayer must hold the property as an investment for at least 24 months after the exchange.
Do Airbnb Properties Qualify for 1031 Exchanges?
A growing number of investors are using Airbnb to generate rental income. The most popular option is to turn a vacation home property into a source of income during periods when it is not otherwise being used. Provided that other 1031 rules are followed, Airbnb properties are qualified for a 1031 exchange.
Using Mixed-Use Properties in a 1031 Exchange
A mixed-use property is one that is used both as a primary residence and in connection with a trade or business, such as:
- An artist has a retail studio inside their home.
- A CPA sees clients in their home office.
- A taxpayer owns a duplex, lives on one side, and rents the other side out.
In such situations, it may be possible to combine both IRS Section 121 and Section 1031 to achieve maximum capital gains tax deferral.
Does Your Property Qualify for a 1031 Exchange?
If you’re still not sure whether your property qualifies for a 1031 exchange or you would like to explore your options, the team at First Guardian Group is here to help. Contact us today to schedule a consultation.