Did you know your rental property could qualify to be sold tax-free? Taxes on the sale of any second homes, vacation properties, or investment properties could eat up roughly 30-40% of your profit! That means for every $100,000 your property has gained in value, you’d owe roughly $30,000-$40,000 in taxes. However, you can avoid these taxes altogether by using an IRS rule called a “1031 exchange” before you sell your property.

Rental properties are great investments to begin with, but many investors are unaware of the additional benefits that a 1031 exchange can provide them when they decide to sell their property.

In the past, if a home was both rented out and used by its owner, it was not easy to determine if it would meet the 1031 guidelines and be an exchangeable property. Although some case law existed, it wasn’t reliable or consistent. In 2008, the IRS attempted to provide some definitive guidance regarding some of these questions in the form of Revenue Procedure 2008-16.  

As the IRS aptly put it:

“The Service recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes. In the interest of sound tax administration, this revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under §1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes.”

By using a 1031 exchange, the IRS allows second homes and vacation properties to be sold tax-free if:

  • The owners have owned the property as a vacation/second home for more than two years.
  • The owners have personally used the property for less than 14 days during the year before the sale, or, have personally used the property for no more than 10% of the days that the property has been rented in the year before the sale.

This revenue procedure made clear that for a relinquished vacation property to qualify for a 1031 exchange, the property has to be owned by the taxpayer and held as an investment for at least 24 months immediately prior to the exchange.  Additionally, within each of the two 12-month periods prior to the sale, the property must have been rented at fair market value to a person for at least 14 days or more, and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented.

The requirements for property to qualify as a 1031 replacement property are very similar.  The property has to be owned by the taxpayer for at least 24 months immediately after the exchange.  Also, within each of the two 12-month periods after the exchange, property must have been rented at fair market value to a person for at least 14 days or more and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented.  The taxpayer is allowed to use the relinquished or replacement property for additional days if the use is for property maintenance or repair.

Some further guidance from the rule are outlined here:

.03 Personal use. For purposes of this revenue procedure, personal use of a dwelling unit occurs on any day on which a taxpayer is deemed to have used the dwelling unit for personal purposes under § 280A(d)(2) (taking into account § 280A(d)(3) but not § 280A(d)(4)).

.04 Fair rental. For purposes of this revenue procedure, whether a dwelling unit is rented at a fair rental is determined based on all of the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the parties to the rental agreement are taken into account.

.05 Special rule for replacement property. If a taxpayer files a federal income tax return and reports a transaction as an exchange under § 1031, based on the expectation that a dwelling unit will meet the qualifying use standards in section 4.02(2) of this revenue procedure for replacement property, and subsequently determines that the dwelling unit does not meet the qualifying use standards, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange under § 1031. .06 Limited application of safe harbor. The safe harbor provided in this revenue procedure applies only to the determination of whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under § 1031. A taxpayer utilizing the safe harbor in this revenue procedure also must satisfy all other requirements for a like-kind exchange under § 1031 and the regulations thereunder.

In Conclusion

Personal use means just that, but there is an exception to the amount of time that you can use the property personally if you are in the process of repairing or improving it.

Also, for 1031 qualification purposes, remember to have a reasonable basis for the rental price that you are charging to tenants.

Lastly, to comply with all the Section IRC requirements of an exchange, remember to amend your return if you later determine that the subject property is a vacation property which will not qualify.  

The IRS requires that investors use a Qualified Intermediary, or Accommodator, like 1031 Exchange Advantage, to set up their 1031 paperwork before investors sell their property. Investors are then required to reinvest their sales proceeds into new pieces of qualifying real estate within 6 months (don’t worry, there are plenty of reinvestment options that don’t require management).

Established in 1978, 1031 Exchange Advantage is an Attorney owned and operated, technology-based 1031 exchange accommodator. With some of the lowest fees in the industry, a patent-pending fraud reduction process, and a 35-year track record of safeguarding client funds, 1031 Exchange Advantage ( 1-866-944-1031)  is the trusted accommodator for thousands of clients and major brokerages nationwide, such as Hubzu.com, Keller Williams Los Angeles, Pacific Sotheby’s, and many more. Visit selltaxfree.com to find out more.

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