Have dreams of starting a short-term rental business? You aren’t alone.
There were more than 1.25 million short-term rental properties available in 2022, a number that’s expected to jump to more than 1.62 million by 2024. Short-term rental occupancy rates, meanwhile, continue to trend up from the Covid-impacted lows of 2020 but still persistently hover under 60 percent.1
Real estate investors seeking to complete 1031 exchanges can diverge from the standard long-term rental model by turning their replacement properties into short-term vacation rentals. The basics of the exchange process remains the same; the main difference is in how you rent out your replacement asset.
The two primary assets involved in a 1031 exchange are the relinquished and replacement properties. The first is the property you are selling; the latter is the property you are buying. An exchange doesn’t have to be a one-for-one swap, either – you can exchange from or into multiple properties as long as property valuations and mortgage debt line up.
You’ll have to make sure you follow all the regulations and meet all the timelines associated with a 1031 exchange. Perhaps no rule is more important to an exchange than the investment and “productive use” stipulation. You can defer capital gains on the sale of your original investment property so long as you exchange into a like-kind asset that’s held for productive use in a trade or business, or the property is held as an investment.
In order to meet safe harbor regarding the productive use and investment stipulation (and reap the tax benefits of the exchange), you’ll have to rent the property out at fair market value for 14 or more days in each of the two years after the exchange is completed. Additionally, your personal use of the property can’t exceed the greater of 14 days, or 10 percent of the time that you had the property rented out as a short-term vacation property. So if you rented the asset a total of 150 days in a calendar year, you could use it 15 days of the year.
You’ll want to hold the asset for a minimum of two years before divesting or converting it to personal use as a vacation home (if that’s your end-goal) to ensure your exchange isn’t challenged by the IRS. This holding period, along with demonstrated rental history to unrelated parties, satisfies the requirement that your replacement property was purchased and held as an investment.
Owning a short-term rental property can be a lucrative business, especially in popular destinations and geographical areas that historically have strong demand for rental properties. Exchanges aren’t limited by state lines, so you could sell an appreciated rental property in Anchorage and purchase a beach house on the Outer Banks of North Carolina and turn that property into a short-term rental. Operate the asset as a rental for a few years and you could even move into the home yourself, or you can complete another 1031 exchange and leverage any built-up equity into a higher-value asset.
1 U.S. Short-term Rental Industry Outlook, AirDNA, https://www.airdna.co/resources