Wouldn’t it be wonderful to have a beautiful vacation home? My clients ask me all the time if they can use a 1031 exchange to accomplish this very thing. It is possible but getting to the finish line can be a bit tricky which is why it is important to use a real estate agent that specializes in 1031 exchanges. Let me give you an example.
You can sell your primary residence and shield $500,000 in capital gain, so long as you’ve lived there for two years out of the past five. But this break isn’t available for your second or vacation home, unfortunately. There are stories all over the place about of taxpayers who were able to use a 1031 to swap one vacation home for another, perhaps even for a house where they would retire. The 1031 would delay any recognition of gain. Later you would be able to move into the new property, made it your primary residence and eventually plan to use your $500,000 capital gain exclusion.
In 2004, Congress tightened that loophole but you are still able to turn vacation homes into rental properties and do 1031 exchanges. For example, you stop using your house, rent it out for a year and then exchange it for other real estate. If you get a tenant and rent it out the home, and converted the house to investment property, it should make your 1031 exchange OK. If you try and be sneaky and hold it for rent without ever having a tenant, that would be not OK. It really just all comes down to timing. The more time that you allow to pass after you convert the property’s use the better it looks.
If you want to use the property you swapped for as your new second or even primary home, you can’t move in right away. In 2008 the IRS set forth a safe harbor rule under which it said it would not challenge whether a replacement dwelling qualified as investment property for purposes of a 1031. To meet that safe harbor, in each of the two 12-month periods immediately after the exchange. First, you must rent the dwelling unit to another person for a fair rental for 14 days or more; and second your own personal use of the dwelling unit cannot be more than the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
To expand even further, after successfully swapping one vacation/investment property for another, you can’t immediately convert it to your primary home and take advantage of the $500,000 exclusion. Before the law was changed in 2004 an investor might transfer one rental property in a 1031 exchange for another rental property, rent out the new rental property for a period of time, move into the property for a few years and then sell it, taking advantage of exclusion of gain from the sale of a principal residence. Now, if you acquire property in the 1031 exchange and later attempt to sell that property as your primary residence, the exclusion will not apply during the five-year period beginning with the date the property was acquired in the 1031 like-kind exchange. To sum it up, you’ll have to wait a lot longer to use the primary residence capital gains tax break.