Yes, you can potentially use a Section 1031 exchange with real estate used for vacations or recreational purposes, but only if it meets specific IRS requirements. To qualify for a 1031 exchange, the property must be considered an investment property or used in a trade or business, rather than primarily for personal enjoyment.
Requirements for Vacation or Recreational Properties in a 1031 Exchange
To qualify as like-kind investment property, vacation or recreational properties must meet the following criteria, outlined in IRS Revenue Procedure 2008-16:
- Rental Requirement:
- The property must be rented at fair market rent to others for at least 14 days per year.
- This rental activity is necessary to demonstrate that the property is held for investment purposes, rather than personal use.
- Limited Personal Use:
- The property’s personal use must be limited to 14 days per year or 10% of the total days it was rented out, whichever is greater.
- Personal use includes any time the taxpayer, their family members, or anyone else using the property for less than fair market rent stays on the property.
- Holding Period for Investment:
- The taxpayer should hold the property for investment purposes for at least two years prior to completing the 1031 exchange.
- Similarly, the replacement property in the exchange must also be held for at least two years after the exchange, meeting the same rental and limited personal use requirements.
Key Points to Consider
- Intent to Hold for Investment: The taxpayer’s intent to use the property primarily for investment purposes is critical. If the IRS determines the primary use was personal, the exchange may be disqualified, resulting in tax consequences.
- Vacation Home to Investment Property: If a property was once a vacation home but is now rented out as an investment, it may qualify for a 1031 exchange if it meets the rental and personal use guidelines for at least two years.
Example of a Vacation Property 1031 Exchange
Suppose you own a beach house that you rent out for 100 days a year to paying tenants, and you use it personally for no more than 10 days a year. You’ve held it as a rental property for the last two years. If you sell this beach house, you could potentially use a 1031 exchange to defer capital gains taxes by purchasing another qualifying investment property, such as a mountain cabin or a rental condo.
In summary, a vacation or recreational property can qualify for a Section 1031 exchange, but it must meet strict requirements showing it is held for investment, with rental use and limited personal use, generally for a minimum of two years before and after the exchange.
