Can a Former Home or Vacation Property Qualify for a 1031 Exchange?

You moved out. The tenants moved in. Now you’re thinking about selling, and the home you lived in could give you an option you hadn’t considered.

That house may be worth more today than when you moved out. Maybe you bought another home and kept the first one as a rental. Maybe a job took you to another city, or you moved into a property you already owned. Either way, if you now own the house as a rental investment, a 1031 exchange may allow you to defer tax on the gain.

There may be a second benefit. If you lived there long enough, and haven’t been renting it out too long, you could also qualify for the Section 121 home-sale exclusion. Together, the two could let you exclude part of the gain from tax and defer the rest of the qualifying gain through a 1031 exchange.

The same opportunity can extend to second homes and vacation properties held as investments. You don’t need an apartment building or commercial property to use a 1031 exchange. If you rent out a house, it’s worth a closer look.

Consider three owners:

• The previous primary residence: An owner moved into another house and rented out their previous home.
• The vacation rental: An owner rents a lake house to paying guests throughout the year and occasionally stays there.
• The personal getaway: An owner keeps a beach house or condo exclusively for vacations.

The first two have a reason to investigate an exchange. The third has a personal-use property, which doesn’t qualify. What matters is how you use the property, not how many houses you own.

A 1031 exchange lets you postpone tax on qualifying real estate gains when you reinvest through a properly structured exchange. Both the property you sell and the replacement property must be held for investment or business use. You don’t have to buy another house. “Like-kind” sounds as though you need to replace a three-bedroom rental with another three-bedroom rental, but your choices are much broader. A qualifying rental home can be exchanged for an apartment building, commercial property, or land held for investment.

An interest in a Delaware Statutory Trust (DST) can also qualify as replacement real estate. A DST provides a way to remain invested in real estate without personally managing another property, giving investors another replacement option.

But what if you still want to enjoy a few weeks a year at your vacation rental? IRS Revenue Procedure 2008-16 provides a “safe harbor”, standards that establish qualifying investment or business use even with some personal use.

To meet this safe harbor for the vacation rental you sell, you must own it for at least 24 months immediately before the exchange. During each of those two 12-month periods, you must rent it for at least 14 days at a fair market rate, meaning a rate comparable to similar properties. You must also keep personal use within 14 days or 10% of the days actually rented, whichever is greater.

If you acquire another vacation rental and use this safe harbor, you must own the replacement property for at least 24 months immediately after the exchange and meet the same rental and personal-use limits in each of those two 12-month periods.

To calculate your personal-use limit, divide the days rented at fair market rent by 10, then compare the answer with 14 days. Use the larger number:

Count only the days your vacation rental was actually rented, not days it was listed or available. If you exchange it for commercial property or investment land instead of another vacation rental, these rental-day and personal-use limits don’t apply to the replacement property. You still need to meet the other 1031 exchange requirements. Missing the safe harbor doesn’t automatically rule out an exchange, but your property’s history will need a closer review.

Personal use includes more than your own visits. Free or discounted vacation stays by friends count, too. Vacation stays by your spouse, siblings, parents, grandparents, children, or grandchildren also count—even if they pay full rent. An exception applies when a family member pays market rent and uses the property as their main home. Keeping a calendar of who stayed, when, and what they paid helps your accountant evaluate the property’s use.

Before listing the property for sale, gather your rental records and personal-use calendar. Have your tax adviser determine whether a 1031 exchange fits your situation, then work with a qualified intermediary to put it in place before closing. Whether you’re selling a previous primary residence, a vacation rental, or a second home held for investment, understanding your options before the sale gives you more control over what comes next.

This article is provided for general educational purposes only and does not constitute tax or investment advice. DST investments involve risk, including illiquidity and potential loss of principal, and are suitable only for accredited investors. Tax treatment depends on individual circumstances. Consult your tax advisor regarding your individual situation. NexTrend Securities is not a tax advisor and does not provide tax advice.