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Can a Vacation Home Be Used in a 1031 Exchange?

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Unless a property owner works as a professional accountant, understanding tax code and all the forms involved with property taxes can feel like a bad dream. Knowing the ins and outs of taxes for a vacation property might even feel a bit nightmarish. Especially when it comes to section 1031 of property taxes. 

A 1031 exchange just means exchanging one income property for another one. There are a few benefits to exchanging investment properties, but first, a property owner must qualify for a 1031 exchange. Even during this first step, there is some confusion among property owners, mainly because there is a variety of opinions on these “property swaps”.

When done properly, though, it is entirely possible to use a 1031 exchange for selling and buying – or should we say swapping – a vacation home. There are a lot of grey areas with this type of property exchange, so read about the specific details below. 

 

Basics of the 1031 Exchange Procedure

When reading the official documentation from the Internal Revenue Service on 1031 exchanging, there is very little clarity on the procedure. This is made obvious through this IRS statement:

“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”

This statement basically just means that an investor can sell a property and reinvest the earnings into a new property. In the process, all capital gains taxes will be deferred. But the process isn’t as easy as selling, buying, and deferring. There are very specific procedures involved, which is why getting expert tax advice is highly recommended. 

 

Benefits of a 1031 Exchange for a Vacation Home

The obvious benefit of the 1031 exchange treatment for a vacation home is the deferred taxes. For a property owner qualifying for one, it is possible to acquire a new home and defer all taxes on the sale. Taxes won’t need to be paid until the property is sold, hopefully, many years later. The best part of all is that there is no limit on the number of exchanges that can be made. 

This means that as soon as a property owner is ready to call it quits on the current vacation home, another exchange can be made for a replacement property. One might compare this to trading in a car after the lease is up. Sometimes all an individual needs is a change in scenery, and a 1031 exchange allows for this – without all the tax hassles that are normally involved with property investments. 

 

An Example of a Vacation Home 1031 Exchange

Laying out the step by step procedure for undergoing a 1031 exchange would be too difficult, mainly since every homeowner’s situation is different. To help understand the process a bit better, here is an example of how a real estate investment would look like with or without a 1031 exchange:

A real estate investor has $400,000 to gain in addition to $400,000 in net proceeds after closing on a property. After the closing date, the tax liability adds up to $140,000 once all combined taxes are tallied up. These taxes include depreciation recapture, net investment income tax, and federal/state capital gain. After all the taxes have been paid, only $260,000 remains in net equity for another property investment. 

Then, with the 25% down payment on a new mortgage that comes with a loan-to-value ratio of 75%, it would be possible to buy a replacement property valuing $1,040,000. However, when a 1031 exchange is filed for reinvesting, the entire $400,000 could be used for a property purchase (instead of just $240,000). This means that the new property could have a higher value of $1.6 million. 

 

Who is Eligible for a Vacation Home 1031 Exchange?

The main requirement for a 1031 exchange is that the exchange is from one investment property to the other. Technically, a vacation home can almost always be considered an investment, no matter if it is being rented or it is meant to be used after retirement. But it takes more than just calling the property a “vacation home” for the IRS to consider these properties investments. 

The first case for 1031 eligibility would be for a property owner to rent out the vacation home for an amount of time greater than 14 days per year. Another viable scenario would be for the owner to reside in the property for less than 14 days per year. If a property owner does not meet either of these requirements, all is not lost. 

Even if the home is not considered an investment property right now, that doesn’t mean it can’t be transformed into an investment property in the future. In other words, if a property owner wishes to complete a 1031 exchange and trade in the old for the new, there are a few options. It is up to the property owner to decide which route is best. 

The owner can either quickly turn the unit into a rental property and start vacation home marketing in order to start booking it out to guests. This will require some work and it certainly isn’t in the cards for every vacation homeowner. The other option is to leave the home vacant for most of the year and only reside in it for 14 days or less. 

This means that the IRS will no longer consider it a primary residence for personal purposes. Now, it can officially be called an “investment property” and is eligible for a 1031 exchange. All in all, using a 1031 exchange is an amazing way to get a change of scenery without paying the absurd taxes that typically come along with property investment. It also allows for a higher investment amount, which in turn can lead to a more lucrative investment in the long run. 

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