A 1031 exchange can be used to defer capital gain taxes on the sale of property held for business, trade or investment. The guidelines for a successful exchange must be followed carefully or the IRS may disallow the exchange. I am often asked whether a property that is used by the owner as a vacation property can qualify. Sometimes it can, but the rules are technical.
Only “qualifying use” of the property will permit a like-kind exchange under section 1031. For example, use as a principal residence is definitely not “qualifying use” but what is “qualifying use” when it comes to real estate that is used as a second – but not primary – residence? The test involves three rules that must be satisfied in order to qualify:
Ownership Period: The property being sold – called the relinquished property – must have been owned for a least 2 years immediately prior to the sale.
Rental Period: Next, the seller must look at their use of the property in each of the two years of ownership prior to the sale, Year 1 (beginning on the day prior to the sale and extending back one year) and Year 2 (beginning on the day prior to the beginning of Year 1 and extending back one year). If the seller rented the property at fair market value for at least 2 weeks of each of Year 1 and Year 2, then the rental period test will be passed. If not, then the test fails at this stage.
Personal Use: Finally, the seller’s “personal use” of the property sold must not exceed a certain threshold. This is the trickiest part of the test. The limitation on personal use is the greater of (1) 14 days, or (2) 10% of the number of days during that period which the property was rented. Let’s take an example. Suppose during Year 1 the owner rented the property for a total of 30 days. The personal use permitted then would be the greater of 14 days, on the one hand, and 10% of rented days (3 days), on the other hand. Since 14 days is greater than 3, we use the 14 number and as long as the seller did not make “personal use” of the relinquished property for more than 14 days during the year then this part of the test will be satisfied. If the owner had rented the property for a total of 150 days during the year, however, then 10% of 150 is 15, and 15 days would be the threshold, not 14. Whatever the number, the personal use cannot exceed this number. If it does, the test fails and the seller will likely not succeed in a 1031 exchange.