A Vacation Property in the context of the 1031 exchange industry refers to a piece of real estate that is used primarily for the owner’s personal enjoyment during vacations or holidays. However, to qualify for a 1031 exchange—a provision of the U.S. Internal Revenue Code that allows investors to defer capital gains taxes on the exchange of like-kind properties—the vacation property must also meet certain criteria set by the IRS.
In a 1031 exchange, also known as a like-kind exchange, properties exchanged must be held for productive use in a trade or business or for investment. Therefore, a vacation property would typically have to be rented out and generate income for a significant part of the year to qualify as an investment property rather than just a personal residence. The IRS has specific guidelines about the number of days the property must be rented at fair market value and the number of days the owner can use the property for personal use.
For instance, the IRS may require that the vacation home be rented out for a minimum of 14 days per year and that the owner’s personal use of the home not exceed 14 days per year or 10% of the number of days during the 12-month period that the home is rented at fair market rental, whichever is greater. These rules ensure that the property is indeed an investment property and eligible for 1031 exchange treatment.
The IRS has issued Revenue Procedure 2008-16 which provides safe harbor conditions under which a vacation property may qualify for a 1031 exchange. This means that if the property owner meets the conditions set out in this revenue procedure, the IRS will not challenge the qualification of the property as eligible for a 1031 exchange on the basis of being held for personal use.
It is important for property owners to consult with tax professionals or advisors who specialize in real estate investments and 1031 exchanges to ensure compliance with the rules and to structure the transaction properly.