My Vacation Home: Applicable Rules and 1031 Exchange
When can my vacation home a primary residence or a mixed-use property be used as a leg in a 1031 exchange? As you might imagine, it takes some preplanning.
Question: Does personal use take priority over the investment use of the property?
Question: Do the properties meet the requirement that both the sold and bought properties are being held for investment or for use in a business?
Can a second home or vacation home be sold or bought as part of a 1031 exchange?
Including a Vacation Home in a 1031 Exchange
If a home has been both rented out and used by its owner, it had been historically difficult to figure out if it would be eligible for 1031 tax deferral.
The IRS did provide some guidance regarding this question in the form of Revenue Procedure 2008-16. As the IRS said:
“The Service recognizes that many taxpayers hold dwelling units primarily to produce current rental income, but also use the properties occasionally for personal purposes. In the interest of sound tax administration, this revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under §1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes.”
This revenue procedure clarified that for a relinquished vacation property to qualify for a 1031 exchange, the property must be owned by the taxpayer and held as an investment for at least 24 months immediately prior to the exchange.
Additionally, within each of the two 12-month periods prior to the sale, the property must have been rented at fair market value to a person for at least 14 days or more, and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented.
The requirements for property to qualify as a 1031 replacement property sound similar. The replacement must be owned by the taxpayer for at least 24 months immediately after the exchange. Also, within each of the two 12-month periods after the exchange, the property must have been rented at fair market value to a person for at least 14 days or more and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented. The taxpayer is allowed to use the relinquished or replacement property for additional days if the use is for property maintenance or repair.
Can a primary residence be converted into an investment property eligible for 1031 tax deferral upon sale?
Rules for Converting a Personal Residence to a 1031 Exchange
The conversion of a primary residence to a property held as an investment and or for business use, or “exchange eligible property,” as defined, may allow an investor to receive a complete exemption of gain pursuant to the rules of IRC §121 upon sale of the property. That code section provides for an exclusion of gain of up to $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly upon the sale of a principal residence. There is a requirement that during the five-year period immediately preceding the sale, the investor/taxpayer must have used the property as a principal residence for at least 2 accumulative years.
Even if the real estate has had principal residence use followed by exchange eligible use, the investor does not necessarily have to do an exchange on the investment/business use of the property if the total gain can be sheltered by the §121 allowed exclusions. So even if during the immediate two years preceding the sale, the property was used as exchange eligible property, the taxpayer may still benefit from the personal residence exclusion.
In the event the gain exceeds the maximums allowed for per §121, the taxpayer may still be able to shelter the balance via a 1031 exchange, thus combining the benefits of these two code sections.
Under Revenue Procedure 2008-16 the conversion of the principal residence to an exchange eligible investment property does not disqualify a family member as the tenant. However, the revenue procedure requires that the tenant paid fair market rent and that it was the family member’s personal residence, not the family member’s vacation home. There are additional rules for the rental of the property by a family member who co-owns the property with the taxpayer.
Should a taxpayer wish to convert the personal residence to exchange eligible property, the taxpayer must have owned the property for the two years immediately prior to the sale and:
1. For each of the years the property must be rented to a person for 14 days or more
2. The taxpayer’s personal use must be limited to no more than 14 days per year or less than 10% of the days per year that property is rented.
Can a property that has been used for investment be converted to a primary residence and what happens if it is sold?
Converting a 1031 Exchange-Eligible Property to a Personal Residence
If an investors intent, based upon facts at the time of the real estate purchase was to hold the property as an investment or for use in a business, the subsequent conversion use of the property to use as a primary residence shouldn’t void the exchange. As an example, an investor might purchase a replacement property of a rental condominium in Florida and upon retirement relocate from a northern state into the condominium as their primary residence.
If the taxpayer subsequently sells the primary residence, there may be the ability to defer the gain under §121.
However, there are some limitations to this deferral upon conversion, otherwise taxpayers might convert exchange property into a principal residence property, sell shortly thereafter, and seek §121 deferral. These rules require that the property must be held for at least five years in total with the period the property was held as an exchange property included.
The period the property was used as an exchange property needs to be backed out of the calculation for the principal residence use deferral. This calculation is made by using the period the property was held as an exchange property as the numerator and the period the property was held in total as the denominator. The resulting fraction or percentage would be applied to the total gain and the resulting dollar amount would not be eligible for a §121 deferral.
Take the example of a property owned by a taxpayer for seven years prior to sale, three of which were used as an exchange property and four of which were used as the taxpayer’s principal residence. Assume that the gain upon sale is $200,000. Dividing the number of three years by seven years x $200,000 results in the amount of $85,714 which is taxable.
Can a mixed-use property be sold with a personal residence exemption and 1031 exchange deferral?
Mixed-Use Property and 1031 exchange
An investor could own a home as the primary residence, but part of the property may have been used as an investment or in connection with a business thereby creating an exchange eligible leg. This is called a mixed-use property. An example might by an acupuncturist who sees patients in a home office. Another example might be a property with a separate house that is rented out. It is quite common for a taxpayer to sell a two flat where the taxpayer uses one unit as the principal residence. In these instances, §121 and §1031 can both be used to achieve total deferral.
A note of caution: With exchanges of mixed use properties and closing statements, there is a tendency to give credits for prorated rent and security deposits to the buyer. This causes the net amount of proceeds attributable to each property use component to be reduced proportionately. Technically, those credits only pertain to the exchange eligible portion of the property and should not appear as a credit on the personal residence portion of the sale.
Conclusion
Nothing stays the same. There are a variety of circumstances surrounding real estate that could be eligible for exchange and may have been used or will be used by the taxpayer as a principal residence or vacation home. Revenue Procedure 2008-16 provides rules regarding vacation homes and exchange eligible property. Likewise, there are rules under IRC §121 for converting exchange property into a personal residence and the reverse. Real Estate that has a principal residence component as well as an exchange-eligible one can benefit by both deferral sections, but care should be taken to get proper advice so that buyer credits affect the exchange eligible portion of the sale only.
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