Vacation Homes and Second Homes Qualify for IRC § 1031?

Vaca­tion prop­er­ties and sec­ond home may be locat­ed almost any­where. Region­al and des­ti­na­tion loca­tions are sought after for a vari­ety of rea­sons. The ques­tions from indi­vid­ual investors may be “can I do a 1031 exchange”.  It depends on many things includ­ing plan­ning and patience.

By Al DiNi­co­la, AIF®, CEPA ™
adinicola@namcoa.com
July 24, 2023
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC

After own­ing a sec­ond home for a peri­od of time the user (poten­tial investor) may be seek­ing a way to sell the prop­er­ty, avoid pay­ing cap­i­tal gains (defer­ring cap­i­tal gains) and move into anoth­er type of real estate. We will expand on the poten­tial per­son­al rea­sons for sell­ing includ­ing seek­ing pas­sive income.

Expe­ri­ence mat­ters

Dur­ing my real estate and invest­ment advi­so­ry role I have lived in Hilton head Island, SC, Naples, FL , Sara­so­ta FL as well as Cape Cod.  All areas that have a vari­ety of sec­ond home, vaca­tion prop­er­ties as well as pri­ma­ry res­i­dents. Many of the part time res­i­dents  may not plan to rent their prop­er­ty. There are a vari­ety of ques­tions regard­ing how to posi­tion those prop­er­ties for a 1031 exchange,

IRS Guide­lines

There is guid­ance pro­vid­ed by the IRS regard­ing 1031 Tax Deferred Exchanges of Vaca­tion Prop­er­ties & Sec­ond Homes. Not all the guid­ance that has been issues is straight for­ward and there is con­fu­sion on the pos­si­bil­i­ty.  In 2008 the IRS issue Rev­enue Pro­ce­dure 2008–16 to clear up the con­fu­sion, sort of.  Safe har­bor lan­guage or guide­lines that address vaca­tion homes and sec­ond home con­ver­sion process into invest­ment prop­er­ty would be the investor’s goal. Invest­ment prop­er­ty would qual­i­fy for IRC § 1013 exchange treat­ment because it would be con­sid­ered “qual­i­fied use”.

March 10, 2008, was the effec­tive date or Rev­enue Pro­ce­dure 2008–16. The cau­tion would be the Rev­enue Pro­ce­dure 2008–16  pro­vid­ed the lan­guage with­in the safe har­bor. Why are you sell­ing your Sec­ond Home or Vaca­tion Home? There are numer­ous safe har­bor guide­lines on a vari­ety of issues with­in sec­tion 1031. A Rev­enue rul­ing in 2004 addressed Delaware Statu­to­ry Trusts (DSTs).  The guid­ance in Rev­enue Rul­ing 2004–86 would sug­gest the investor can enter into and com­plete a 1031 exchange uti­liz­ing a DST.

Why are you sell­ing.

There are many rea­sons for sell­ing your home.  In today’s real estate mar­ket many areas have expe­ri­enced increased val­u­a­tion and despite the increase in inter­est rates there are plen­ty of cash and for­eign buy­ers who may have an inter­est.  The oth­er rea­son may be that the sec­ond home or vaca­tion prop­er­ty is too hard to man­age from a dis­tance, investors are get­ting old­er (baby boomers see past arti­cle) and investors may want to move into a more pas­sive own­er­ship role and receive pas­sive income.  Since 2004 DSTs have pro­vid­ed that alter­na­tive.

Require­ments are strict.

The 1031 Exchange Tax Deferred process has a vari­ety of require­ments.  Any require­ments that are not met will dis­qual­i­fy any tra­di­tion­al exchange. Oper­at­ing with­in the guid­ance for vaca­tion prop­er­ty or a sec­ond home may enable the investor to qual­i­fy for the tax treat­ment of the 1031 exchange process. What are the guide­lines Safe Har­bor Guide­lines for Vaca­tion Homes or Sec­ond Homes Held as Relin­quished Prop­er­ty. The main ques­tion from investors would be how the sale of the  vaca­tion home being sold may be includ­ed in a 1031 exchange. 

Plan you course of action.

• Own­er­ship of the sec­ond home or vaca­tion prop­er­ty poten­tial­ly involved in a 1031 exchange (the sub­ject prop­er­ty or relin­quished prop­er­ty) should be owned by the investors for 24 months. This peri­od of time is known as the “qual­i­fy­ing use peri­od”.  That means if you owned your prop­er­ty for 8 years you need to retain for anoth­er two years as a rental.
• Rental require­ments include the prop­er­ty must be rent­ed at fair mar­ket val­ue. The investors should have records that can reflect the prop­er­ty has been rent­ed for a min­i­mum peri­od of 2 years before enter­ing into the sale and exchange. This includes claim­ing on your tax returns. Offer­ing the prop­er­ty for as a  rental and then for sale must hap­pen.
• The Rental Peri­od for the prop­er­ty must be for a peri­od of 14 days (or more) dur­ing the peri­od of the two (2) years.
• Per­son­al use is restrict­ed. This may be where the investors needs to pay spe­cial atten­tion. The investor can only use the sec­ond home prop­er­ty for a peri­od of 14 days dur­ing each of the 2 years. . There is also anoth­er cal­cu­la­tion regard­ing per­son­al use. If the prop­er­ty was rent­ed for 9 months of the year (270 days) then the investor may use the prop­er­ty for ten per­cent (10%) of the 270 days or 27 days.
• Not so friend­ly friend and fam­i­ly mem­bers may request time in the sec­ond home. If the investor pro­vides use to fam­i­ly mem­bers, this is con­sid­ered per­son­al use and will count against the per­son­al time.  Any dis­count­ed rents charged to fam­i­ly mem­bers or oth­er par­ties will also be regard­ing as per­son­al use.

Learn­ing from investors and CPAs

We are for­tu­nate to inter­face with count­less investors, CPAs, and oth­er advi­sors. We always enjoy learn­ing new strate­gies even after four decades of real estate and secu­ri­tized real estate invest­ments.  A few years ago, we had an inter­est­ing con­ver­sa­tion with a prop­er­ty own­er in Naples, Flori­da.

• The prop­er­ty own­er and her hus­band pur­chased a beach front prop­er­ty for $1M in the late 1990s.  Dur­ing their own­er­ship they made cap­i­tal improve­ments to the home that is known as adding to the basis of the home. 
• As the years went by the cou­ple decid­ed to trav­el.  They had anoth­er prop­er­ty in the mid-west and grown chil­dren (and grandchildren)around the coun­try. Rather than leave their beau­ti­ful beach front home in Naples sit unoc­cu­pied they rent­ed the home for six (6) months out of the year.
• The rent and rental of the home was report­ed on their per­son­al income tax­es for years. The prop­er­ty served a dual use. The hus­band passed away and the wife (then in her 80s) decid­ed to sell the home. The wife want­ed to down size and move into a home that had less upkeep.
• The home was list­ed for sale and sold with­in two (2) years.  The home sold for about $12 mil­lion after 20 plus years of own­er­ship and 8 years of being rent­ed. 
• Under the guid­ance of their CPA (and with out any input from use since we do not pro­vide tax advice) the sale was bifur­cat­ed into two parts: a per­son­al res­i­dence sale and an invest­ment sale. 
• $6M was accred­it­ed to the per­son­al res­i­dence and $6M to the 1031 exchange.
• Upon clos­ing the $6 M cred­it­ed to the res­i­den­tial sale uti­lized the basis of the pur­chase $1M plus the cap­i­tal improve­ments (adding a pool, expand­ing the home, etc.) that added to the basis.  The own­er uti­lized the $500,000 exemp­tion pro­vid­ed by IRC §121 to arrive at a net sell­ing price that was sub­ject­ed to cap­i­tal gains.  Sell­ing the prop­er­ty with­in two years of her hus­bands death qual­i­fied for the full $500,000 exemp­tion.
• The invest­ment sale uti­lized a 1031 exchange. $6M was direct­ed by the clos­ing agent to the Qual­i­fied Inter­me­di­ary to be uti­lized in a 1031 tax deferred exchange.
• The wife now was free to invest into oth­er invest­ment prop­er­ties (many pas­sive income) pro­vid­ing her an income streams sim­i­lar to what she was accus­tomed to when rent­ing her home for 6 months.
• We can­not opine that this strat­e­gy will work for all investors in all sit­u­a­tions. How­ev­er, with the increase in many investors’ per­son­al res­i­dences and the IRC §121 is lim­it­ed to $500,000 for mar­ried cou­ple investors are seek­ing oth­er strate­gies. Remem­ber there are safe har­bor require­ments for real estate and typ­i­cal­ly in rev­enue rul­ings.

As always- pro­ceed with cau­tion.

As we  always men­tion we are not per­mit­ted to pro­vide tax advice and that is their respon­si­bil­i­ty of the investor’s CPA. Every trans­ac­tion must be suit­able to indi­vid­ual investors.  Ref­er­enc­ing Rev­enue Pro­ceed­ing 2008–16 may be a good start­ing point for your CPA to start pro­vid­ing insight.

DSTs are not for all investors.

The acqui­si­tion of a DST is for accred­it­ed investors only. Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin ‑Sher­wood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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