Can You Do a 1031 Exchange on a Short-Term Rental Property?

The purpose of a 1031 exchange is to defer the obligation to pay capital gains tax when you sell an investment property. The IRS has explicit rules governing these transactions, including tight timelines and requiring the taxpayer to use a Qualified Intermediary to oversee the financial and reporting aspects.

According to the applicable Internal Revenue Code section, real estate assets that are eligible for exchange using this means must be held for productive use or investment. A short-term rental property meets that definition and can be acquired or disposed of using the 1031 exchange tool. The IRS is generous with the application of the rule. For example, the investor can exchange almost any type of real estate asset for any other type as long as the relinquished asset has been held for investment or productive use. So, an investor might swap vacant land for a retail outlet or multifamily housing for a self-storage facility.

What are the essential rules for an exchange?

The timelines for qualification are stringent. Following the sale of the original (relinquished) property, the investor must identify potential replacement properties within 45 days and complete the acquisition within 180 days. The identification of replacement property is a formal notification by the investor to the QI and may include more than one property, following these parameters:

1.     Identify up to three possible replacements, each of which has a value equal to or greater than the relinquished property.
2.     Identify any total number of properties as long as the combined value of the pool doesn't exceed 200 percent of the relinquished asset's value.
3.     Identify as many properties as you like, then acquire at least 95 percent of the total identified value.

In any case, the investor must reinvest the entire proceeds from the sale in replacement assets.

Additional rules apply to rental property.

However, rental properties may receive some additional scrutiny to determine whether the property is, in fact, held for investment or is a personal use property. The IRS created a safe harbor definition for rental properties that applies whether the use is short or long-term. The owner should satisfy these requirements:

1.       The owner has held the property for at least two years immediately preceding the 1031 exchange.
2.       During that period, the taxpayer rents the property to others at a fair market price for at least 14 days each year.
3.       The taxpayer’s personal use of the property during that time is less than 14 days or 10 percent of the total days the property is rented to someone, whichever quantity is greater.  

Keep in mind that if the property you acquire using the exchange is also a rental, you will need to satisfy the safe harbor requirements for that asset following the exchange. Failure to do so could result in a retroactive disqualification of the deal. Furthermore, renting the property to others at less than fair market value could also lead to a challenge since the IRS might question the actual intent of the investor. Finally, a 1031 exchange disqualified for any reason will require the investor to pay the capital gains taxes on the relinquished asset.