The Internal Revenue Sevice (IRS) will not challenge whether a vacation property is held for proper intent in a 1031 exchange if held for the periods stated in Revenue Procedure 2008-16.
Effective on and after March 10, 2008 the safe harbor for 1031 exchange vacation properties are the following:
Relinquished or Old Vacation Property
- hold time of two years;
- in each of those two years, the property must be rented 14 days or more at fair market rent;
Replacement or New Vacation Property
- hold time of two years;
- in each of those two years the property must be rented out 14 days or more at fair market rent.
Personal use for 1031 exchange vacation homes must be no greater than 14 overnights or 10 percent of the days rented per year. The IRS provided these guidelines as a bright line test for vacation property owners and their professional advisors. Vacation properties can be exchanged in less than the periods stated in the IRS Rev. Proc. but could be subject to IRS review.
1031 exchange eligible properties range from homes, rental and condominiums along the coast, to lake cottages and condominiums. They each provide the investor with an opportunity to hold the property as an investment for appreciation deducting yearly expenses and depreciation.
Each 1031 vacation property exchange is supported by intent and facts that support the intent. The intent is to hold the property for investment or use in a business. Intents can change based upon health, work, and family. Facts such as hold time, personal use and whether the investment property is itemized on Schedule E of the Exchangor's annual tax return are facts that support the intent. The IRS Schedule E asks how many days were used for personal use. If when staying at the investment property, maintenance is performed, be sure to inform your CPA given those overnights are not counted towards the fourteen overnights permitted. If the property is sold earlier than two years, the Exchangor assumes the risk that their facts will support the abbreviated hold time. Reporting the vacation property on Schedule A is a clear indication the property is not an investment but a second home.
Vacation properties held in a 1031 exchange can be converted to a primary home following specific IRS guidelines. A second home can be converted to an investment property, changing the character by placing the property into a rental pool, reducing personal use and itemizing the property on Schedule E on tax return.
A variety of 1031 exchange strategies are used to either sell the old property first in a forward exchange, acquire the new property before selling the old one as in a reverse exchange, build on land already owned before selling the old property in a leasehold improvement exchange or acquire and improve the new property in a build to suit exchange.
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