Can I Do a 1031 Exchange on My Vacation Rental or Second Home?

1031 Pros
Apr 28
4 min read

In limited situations, you can do a 1031 exchange on a second home or vacation rental. You must prove that you’ve used these properties as investments for the majority of the time. That means you’ll need clear records and plenty of notes.

We’ll explain how these delicate transactions work and help you make the best decision for your portfolio.

What Is a 1031 Exchange?

A 1031 exchange (sometimes called a deferred exchange) is one in which an investor sells one property and buys another in one complex and intertwined transaction. The Internal Revenue Service (IRS) explains that the assets must be properties held for productive use. In other words, they must be investments and not residences.

After the sale of an investment property, most people are hit with capital gains taxes. In a 1031 exchange, those taxes are deferred and wrapped into the new property. They aren’t due until the replacement property is sold.

For an exchange to work, the investor must hire a qualified intermediary to facilitate the transaction. This entity holds the profits if the sale happens first. The entity parks the property if the replacement property is purchased first.

A qualified intermediary can help you understand how these exchanges work. However, it’s important for you to do your homework first. Here’s what you need to know about these transactions.

Understand Property Rules for 1031 Exchanges

The IRS has strict rules about the types of properties that can be bought and sold in a 1031 exchange. Understanding those rules is an important part of deciding what to do with your vacation rental or second home.

Per the IRS, the transaction must involve property that is “held for productive use in a trade or business or for investment.” In other words, these are properties you own to make money, not to enjoy independently.

IRS Proc. 2008-16 suggests that the property you’re selling in a 1031 exchange must meet these rules:

You’ve owned it for at least the 24 months immediately before the sale. That time frame is broken down into two 12-month periods.
Within both time frames, you must have rented the unit to another person for 14 days or longer.
Within both 12-month time frames, your personal use of the dwelling isn’t larger than 14 days or 10% of the number of days that the dwelling is rented.

So what does this mean?

Can You Do a 1031 Exchange on a Second Home? What About a Vacation Home?

In limited situations, you can perform a 1031 exchange on a second home or vacation rental.

The following two potential scenarios exist:

You have a property that you use as a rental for 90% of the time.
You have a property you rent for 14 days per year and live in for 12 days per year.

If you can’t meet these scenarios, you can’t perform the exchange by selling your second home or vacation rental.

What About Appreciation?

IRS rules state that properties in 1031 exchanges must involve properties held for use in trade or for investment. Some investors read these words and believe they can exchange almost anything that makes them money in time.

In many markets, real estate passively gains value year over year. You may not like the place you call home, but you might keep it because it becomes a more valuable asset with time. Given this logic, you may believe you could exchange almost anything that’s worth more now than it was when you bought it. Unfortunately, that’s not true.

In 2007, taxpayers tried to perform a 1031 exchange involving two lakeside vacation homes. Neither property had ever been rented, but the owners considered them investments as they were expected to increase in value. The tax court disagreed and asked the family to pay the capital gains taxes they’d hoped to avoid.

In the eyes of the IRS, a property like a home or apartment is only an investment when it’s put to work via rental agreements. An expectation of profits at the sale isn’t enough.

Providing Proof of Investment

If you’d like to sell your second home or vacation rental through a 1031 exchange, you’ll need proof and paperwork. It’s never too early to begin collecting critical documents. If you neglect to gather necessary paperwork, you’ll have to scramble down the road to make it happen.

Start with Schedule E of Form 1040. When you file your taxes, your property should be listed on this form as an investment. Filing this document every year tells the IRS that you consider this property an investment.

Next, consider your rental agreements. Ensure they have move-in and move-out dates clearly marked. If you must show the IRS that you’ve made money on the property and had it rented most of the time, these documents will be invaluable.

Finally, ensure that your renters pay you in trackable ways, such as checks with “rent” in the memo field. You can pull them up quickly if you’re asked for proof of investment.

If you live in the property, be smart. Don’t change your mailing address to the rental for long periods, or the IRS will assume you’re living there longer than you’ll admit.

Get Help With Your 1031 Exchange

Can you do a 1031 exchange on a second home? Can you exchange a rental home? You can, but the rules are complicated. You need an expert’s help to make these transactions work.

At 1031 Pros, we have the experience and expertise you need to get your 1031 exchange completed easily and seamlessly. We focus exclusively on 1031 transactions, so these are the only types of deals we handle. This means you’re working with experts when you choose us as your partner. Contact us to find out more about our services and get started today.