When Does Vacation Property Qualify for a 1031 Exchange?

As the weather gets warmer, taxpayers buying and selling vacation homes may assume their property does not qualify for a 1031 exchange.

However, in cases where vacation property has been primarily held for investment or business use, with occasional personal use, it may be possible to defer capital gains tax through a 1031 exchange.

In order to defer capital gains tax through a 1031 exchange, both the relinquished and replacement properties must be held by the exchanger for productive use in a trade or business or for investment, not for personal use.

However, some properties, like vacation homes, may be used for both personal and business or investment purposes. For example, many taxpayers who own vacation property may rent the property to others for the majority of the year, but still occasionally use it for personal enjoyment themselves.

To account for these situations, the IRS issued Revenue Procedure 2008-16, which provides a safe harbor allowing dwelling units to qualify for §1031 exchanges despite limited use for personal purposes.

To fulfill the safe harbor requirements and qualify for a 1031 exchange, the taxpayer must hold the relinquished or replacement vacation property for at least two years directly preceding or following the exchange. In each of the two 12-month periods preceding or following the exchange, the taxpayer must rent the property at fair market value for at least 14 days. However, the taxpayer may use the property for personal purposes for up to either 10% of the number of days the property was rented within the 12-month period or 14 days, whichever is greater.

Both the relinquished and replacement property being exchanged must meet the productive use or safe harbor requirements. Failure to comply with these requirements could jeopardize the outcome of the exchange and result in significant tax liability.

NES Financial is the leading independent 1031 qualified intermediary in the country. Our clients include Fortune 500 companies and major real estate companies, and our expertise is unparalleled.  In fact, our General Counsel developed significant 1031 guidance during her tenure at the IRS National Office in Washington, D.C.

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