Using Section 1031 for a Vacation House is Possible if Done with Care

Personal-use property cannot be exchanged under Section 1031, but personal use property can become investment property or business property, Taxpayers can convert a vacation home into rental property, and later the rental could conceivably be traded for other real estate in a 1031 exchange. However, after converting the property to a rental, and before the 1031 exchange, the taxpayer needs to continue renting the property for a long enough time to convincingly convert from personal use to investment property. Although there is no mandatory minimum time, it is probably not enough time if less than one year. You must actually seek a fair rental amount, obtain real tenants, sign real estate leases or rental agreements, account for the rents and expenses, and manage the rental property like a real business. Converting a house to a bona fide rental can succeed (but with no guarantees) in this way, which thereafter allows you to replace the property in a 1031 exchange. But you might invite an audit if you report no rents or are considered to do the conversion within too short a time before the 1031 exchange.

After you complete that 1031 exchange, suppose that you might want to convert the replacement property into a new home. In this case you should wait even longer than before the 1031. You should continue to use the property solely for business or investment purposes, and not even consider moving into the property, for at least two years. The IRS offers a safe harbor rule under which the preceding 1031 exchange will not be challenged. However, an earlier conversion to personal use probably could disqualify the replacement property as an investment property for purposes of a 1031. To satisfy the safe-harbor requirements, in each of the two 12-month periods immediately after the Section 1031 exchange: (1) you must rent the dwelling unit to another person for a fair rental for 14 days or more; and (2) personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days that the unit is rented at a fair rental.

You should be aware that once a property has been exchanged under 1031, the $500,000 (married filing jointly) or $250,000 (individual filers) exclusion from the capital gains from a sale of a principal residence will not apply during the five-year period beginning with the date the property was acquired in the 1031 exchange. In other words, you will need to wait until five years after the 1031 exchange in order to sell the principal residence while utilizing that exclusion. For instance, if you rent the property for two years after the 1031 exchange, and converted it into a second home, you would need to live in the home for two years anyway to obtain the exclusion, but you would also need to wait at least one more year to sell the second home because you cannot use the exclusion until 5 years after acquiring the property in the 1031 exchange.