The IRS recently litigated a case that shed some light on whether or not vacation homes can qualify for a 1031 exchange. In the case, the clients used a vacation home for 100 percent personal use and tried to claim 1031 status. The court ruled in favor of the IRS. The client showed no rental history on the unit. For all substantial purposes, this property was a second home, and second homes with no rental history do not qualify for a 1031. The typical example of a second home would be snowbirds that own a property up north, and a second home in Florida that they use 3-6 months a year.
Just because you have a vacation home, do not assume it will not qualify for a 1031 exchange. Below are some tips that might help in converting a vacation property into an investment property that might qualify for 1031 treatment. The intent of the property at the time of sale and purchase is very important in 1031 exchanges.
- Don’t use the property a year before you sell it, or don’t list it for sale during that year.
- Try to rent out the property before you sell it or put it in a rental pool available to rent.
- Deduct mortgage interest on Schedule E if you have rental income, or as investment interest on Schedule A. Do not deduct it as home mortgage interest. Also, if you have expenses, deduct them on Schedule E as bona fide rental costs.
- Don’t make major personal improvements to the property. Maintenance costs are fine, but don’t put in the Jacuzzi tub because the IRS would not see that as a reasonable cost.
- If you rent the unit to friends or relatives, be sure to charge them fair market value rent.
- Finally, the IRS will look more favorably on a standard rental versus a large million dollar home that is difficult to rent.
One thing about 1031 exchange properties is that each exchange is unique. So by following the guidelines above, you try to show the IRS that your property was in fact an investment, which is eligible for 1031 treatment.
Please be sure to consult your tax advisor before starting a 1031 exchange to be certain your property will qualify.