Vacation homes are often located in quickly appreciating, desirable areas with limited supply (oceanfront and mountainside lots are inherently finite). This means you need a considerable amount of cash to purchase one. And that you'll face a tax liability when it comes time to sell.
You may buy a vacation home with the intent to live in it one day or use it occasionally. In that case, you have options to defer or reduce your tax liability through the use of a 1031 exchange, a personal sale exclusion, or both.
What is a 1031 exchange?
A 1031 exchange lets you sell one investment property and use the proceeds to buy another -- without paying capital gains taxes. You can defer your capital gain as many times as you want.. There are various rules of process and timelines you must follow in order to execute the transaction legally. But when it comes to vacation homes, the process is more complex.
The rules are different for vacation homes
If you hold a vacation home solely for investment without renting it for income, it's ineligible for a 1031 exchange.
To minimize the likelihood of a Tax Court challenge, see if your property meets the IRS’s "safe harbor" rules for a 1031 exchange of a vacation home. These are the important factors:
- The property you are exchanging is of "like kind."
- The property you are exchanging is used for "productive use" in business or for investment, meaning it helps you earn income.
- You’ve owned the property for at least 24 months prior to the exchange, or you own the replacement property for at least 24 months after the exchange.
- Within each of the two 12-month periods prior to or after the exchange, you rented the property at fair market value 14 or more days per year, and your personal use of the property was limited to 14 days or 10% of the number of days rented at fair market value, whichever is greater.
If you plan to purchase or sell the property in a 1031 exchange, you need to have your taxes in order.
Have two years’ worth of tax returns showing income and expenses taken on the property to prove productive use and intent. Time spent at the property for repairs and renovation could be excluded from the personal use limits. So keep diligent records of your time spent there and why.
Minimize taxes even if you use it or want to live in it
What if you've used the vacation house primarily for personal use? You can’t qualify for a 1031 exchange, but you may still qualify for special tax treatment.
You need to satisfy two conditions:
- The vacation house was your primary residence for at least 24 of the previous 60 months.
- In any given 12 month period, you spent more than half the year in it.
In this case, you can exclude $250,000 of capital gains if you’re single or $500,000 if you’re a married couple. You could move into your vacation home for two years prior to selling to capitalize on the tax savings from a personal sale exclusion.
If you acquired your vacation property through a tax-deferred 1031 exchange and convert it to your primary residence, that’s okay. But you cannot take the exclusion if you sell it within five years of the exchange. The best scenario is to rent it out for five years, then convert it to a primary residence for two years. Then you could exclude the eventual gain under the home sale exclusion.
This is a little-known way to convert a replacement vacation home that you've used as an investment or for business. By converting it to your primary home, you can save on taxes. As long as you're willing to give it some time, that is.
You have other options in this case, too. Once you've converted the property to a primary residence and owned it for at least five years, it can be given split treatment as an investment property and primary residence. There are two scenarios where you can do this:
- Your property was treated as an investment property when you sold it, but you’d previously used it as a primary residence for two out of the immediately preceding five years.
- Your property is not entirely your residence and may qualify partly as an investment.
Confirm your strategy with the experts
Buying or selling a vacation home with a 1031 exchange is complicated. If you have any doubts about whether you're following the proper procedure, consult a tax professional. They can tell you how to structure your 1031 so it follows all the necessary regulations.