Vacation Homes and 1031 Exchange: How They Fit Together

Owning a vacation home is a popular goal among homeowners. Whether the intent is to rent it out for additional income or to use it as your own private getaway, there are financial aspects of owning a vacation home that are important to consider. Vacation home purchases are expensive up front and can also incur large amounts in capital gains tax if you ever choose to sell the property. However, it is possible to defer taxes and save money by using a 1031 exchange in some cases.

1031 Exchange Basics

A 1031 exchange is a special transaction that allows you to sell one investment property in “exchange” for another. This works by using part or all of the proceeds from the sale in obtaining the new investment property. This is a way for investors and sellers to save money on their taxes by deferring capital gains tax on any profits from the sale. The process is already complex, but for vacation homes there are additional rules that apply.

Safe Harbor Rules

In order to be eligible for a 1031 exchange, you will need to make sure your vacation property follows all the IRS “safe harbor” rules. We can break those requirements down as:

• You can only exchange “like-kind” properties. This is a requirement for all 1031 exchanges, regardless of the property type. It simply means that the property gained in the exchange must also be for investment long term.

• The property must be used for “productive use” in business or for investment. This means the property generates income.

• You have to own a property at least 2 years before exchanging it, or own the “replacement” property for at least 2 years after acquiring it.

• In each of those two years, you must rent the property at fair market value for at least 14 days. Your personal use of the property must also be less than 14 days (or less than 10% of the time it was rented out, whichever is greater).

All of this means you will need to keep organized and detailed tax records for everything within that 2-year period. Make sure you can provide tax returns proving the income generated from the property and also record any time you spent personally in renovations, improvements, etc. Time spent working on the property does not count as your own “personal use” so carefully note the reasons for your visits.

If Your Property Doesn’t Qualify

If you mostly use your vacation home for personal use, it will probably not be eligible for a 1031 exchange. However, you might still save on taxes in other ways if you’re buying or selling. It all comes down to how long you own the home compared to the time you actually live in it. If you live in the property (“personal use”) for at least 2 of the previous 5 years, you can still exclude a fairly significant amount from your capital gains tax when you sell. If you purchased a property through a 1031 and later turned it into a personal residence, you can defer the exclusion as long as you live there for at least 5 years.

Timing is everything in determining whether you can buy or sell a vacation home through a 1031 exchange. Pursuing this kind of transaction takes lots of planning, organization and help from qualified professionals. If you’re unsure about whether your property or a property you want to buy will be eligible for a 1031, consult an expert.