If you’ve ever dreamed of selling your dreary rental home in the Rust Belt and completing a 1031 exchange into a relaxing vacation home in a sunny beachside community, keep on reading.
There are strict rules that must be followed during a 1031 exchange in order to defer capital gains taxes on the sale of an investment property. Your vision of selling your rental in Toledo and purchasing a vacation home in Hilton Head may not pass 1031 qualified use requirements and result in a disqualified exchange.
In order to enact your plan, you’ll have to be strategic. Here’s how you can 1031 exchange from a rental property into a vacation home.
IRS Code Section 1031 Qualified Use Requirements
Section 1031 of the Internal Revenue Code allows real estate investors to defer taxes on realized gains from the sale of investment properties provided they roll the entire sale proceeds over into a like-kind asset.
Some hard rules include:
- Exchangors have 45 days from the date of sale to identify a replacement asset.
- Exchangors must use a qualified intermediary to facilitate the exchange.
- Acquisition of the like-kind replacement asset must be completed within 180 days from the close of sale on the relinquished property.
In order to pass the qualified use test, both properties must be held for investment purposes – at least for a time. Generally, you’ll have to have rented out your relinquished asset for a period of 24 months prior to sale, and put your replacement asset into service as a rental property for a minimum of another two years. If you divest the replacement asset prior to that 24-month window, your 1031 exchange could be disqualified since you effectively cashed out of the investment.1 You’ll also be liable for any capital gains taxes generated from the sale of your original investment property.
So while you can’t just sell a rental home held as an investment and complete a 1031 exchange for your dream vacation home in the Carolinas, you can eventually live in the replacement asset. Here’s how.
How To Turn a 1031 Exchange Property into a Vacation Home
A vacation home or second home can qualify for tax-deferred exchange treatment under IRS Code Section 1031 if the asset was rented out for a minimum of 14 days in at least two 12-month periods of ownership. You must be able to show that you rented out the vacation property for a minimum of two weeks in two years (they don’t have to be consecutive) in order to meet the qualified use requirements that the property was purchased as an investment.
It’s easy to meet qualified use requirements if you rent the property for more than 15 days each year. The home can’t be used as your primary residence in the interim, however – renting the house out to your brother for two weeks each year won’t put you in the clear.
The Bottom Line
One path to eventually living in a vacation home you acquired as part of a 1031 exchange is to place the asset into service as a rental for a minimum of two years. Once you have that documented rental history, you can demonstrate that the asset was purchased as an investment rather than a primary residence or second home.
Living in an asset you purchased through a 1031 exchange is likely to raise some red flags. Consulting with a tax professional who has experience with this type of 1031 exchange transaction can help you avoid making any grave mistakes that could result in a disqualified exchange.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
