Qualification
A so-called “vacation home” is really just a second personal residence.
It doesn’t take on a new identity because you stay in it while you are on vacation, or wearing shorts, or are away from your primary residence for the weekend.
Even if you don’t stay in it, and you only bought it for investment, the IRS still does not consider it qualified for treatment as an investment property under the Section 1031 requirement of “real property held for productive use in a trade or business or for investment.”
A second home or vacation home will not qualify as Relinquished Property in a Section 1031 Like Kind Exchange if it is currently used exclusively for personal use, regardless of how long you have owned it.
And, a second home or vacation home will not qualify for Replacement Property in a Section 1031 Exchange if you plan to use it exclusively for personal use after you acquire it.
However, a second home can qualify for both Relinquished Property and Replacement Property.
To do this, you use it for rental income as well as personal use.
This means that you treat it as an investment property, and that you also use it personally for some amount of time as a “vacation home.”
The rule for a vacation home is that it must be listed for rental, usually with a Property Manager or by running ads in the newspaper, and that your personal use must not exceed a certain amount.
The amount of personal use permitted is the greater of
- 14 total days during the tax year, or
- 10% of the actual number of days the property is rented.
So, if you use the property for personal use at least 14 days each year, or if you use it more, it must be rented out for 140 days plus 10 more days for each day over 14 that you use it. That satisfies the 10% requirement.
Otherwise, it does not qualify as Relinquished Property for Section 1031 Exchange treatment if you sell it.
Also, if you buy a second home or vacation home as a Replacement Property, the same rules apply, and the IRS is very strict about this.
During the time that you own the vacation home, the rental income and details of your personal use of the home, are reported on Schedule E, which is attached to your Form 1040.
If you plan to qualify the property as Relinquished Property, you probably should be able to show, through rental income records, how the property was used for at least two years prior to the Exchange.
If you plan to qualify the property as Replacement Property, you should begin immediately after purchase to qualify and continue through the remainder of the tax year, and another full tax year to avoid any question.
Since this is a frequent source of conflict with taxpayers, the IRS has provided details in Publication 527.
The IRS will not question whether a dwelling unit was held for use in a trade or business if the taxpayer has owned the Relinquished Property for at least 24 months prior to the Exchange Date (not two tax years, but 24 consecutive months), and rented it for at least 14 days each of those two 12-month periods, and has not personally used it for more than 14 days, or 10% of the total number of days rented, whichever is more, for each of those two 12-month periods.
For Replacement Property, the same rules apply.
Do this, and the IRS will not challenge the use qualification.