Throughout the years of consulting people regarding 1031 properties, one question keeps popping up:
Can a second residence such as a vacation home qualify as an exchange property?
The short answer is no. Because 1031 exchanges are specifically for investment properties, residences do not qualify as a 1031 property.
BUT… like most tax laws, however, there are ways to manage your estate so that you can take advantage of tax-deferment benefits of 1031 exchanges.
How to turn a second residency into a 1031 property
1031 properties are investments first, and to establish the property as an investment, the owner may not live in the property for an extended period of time during the first 5 years of ownership. What qualifies as extended? The guideline is no more than 2 weeks, but that time can be extended based on how often the 1031 property is rented to others. The owner cannot reside at the property for more than 10% of the time the property is actively rented. Put another way, for every 10 days the property has an active tenant, the owner may reside there one day.
This makes owning vacation rentals in lucrative markets a smart 1031 investment. It is still possible for the owner to vacation in the home one or two times a year while maintaining the 1031 status of the property. The more successful the rentals, the more time the owner is allowed to stay on the property, without considering it a true second home. A property owner with several properties in a single area can successfully “hop” from property to property to extend their stay. In five years, the preferred property can be converted to a true second residence, leaving the additional properties as 1031 properties. Of course, once an investment property becomes a residence, it will no longer be a 1031 property, but may qualify for a 121 exemption.
By investing in a property that has the potential of being a second residence, investors are able to take advantage of a 1031 exchange. This is an important distinction over buying a property with the intent to treat it like a second home – one that is never rented to tenants or that is immediately used as a second home.
Acquiring and property maintaining 1031 status on a property is more complicated than a basic “sell and reinvest the profits” strategy. For a free consultation and to learn more about leveraging Section 1031 in your investment portfolio, please call Chris Schellin, president of Westwood Net Lease Advisors at 314-563-2208, [email protected], or click here to use our contact form