The 1031 exchange is a popular IRS provision which allows property owners to sell one piece of real estate and buy another, using the proceeds, without incurring a tax obligation. The catch is that both properties must fall under the definition of investment property. A gray area sometimes develops in regard to vacation homes, where the owner uses it as a residence part of the year but rents it out the rest. To the rescue comes the IRS with a relatively clear “safe harbor” definition that lists a set of conditions that, if met, precludes them from challenging your designation of a property as for investment.
The following list of conditions are intended to offer guidance to those planning on conducting a 1031 exchange. It makes reference to a dwelling unit, which is defined as a house, apartment, condominium, or other improvement that provides basic living accommodations that includes a sleeping space, bathroom, and cooking facilities.
You must have owned the property you’re selling for at least 24 months prior to the sale and the replacement property must be owned at least 24 months after the sale. The latter is known as the qualifying use period. During each of the two qualifying 12 month periods the taxpayer must:
Rent the property to another person or persons at a fair rental for 14 or more days; and
2. The taxpayer’s personal use of the dwelling unit cannot exceed the greater of 14 days or 10 percent of the number of days during the 12 month period the dwelling unit is rented at a fair rental.
According to the IRS, if you abide by these conditions, you will have no worries about being challenged by the agency after the qualifying period as to whether or not either end of the 1031 exchange was, in fact, NOT an investment property. It would, of course, be an excellent idea to keep proof of the dates you used the property versus when you had it rented out, and consulting a tax professional or real estate attorney would be advisable as well. If their interpretation of the “safe harbor” is the same as yours, you can sleep better at night knowing the tax man won’t be knocking at your door with a large bill.
The MHP Listings Team
Flickr / Discount Vacation Rentals Online