Vacation properties and second home may be located almost anywhere. Regional and destination locations are sought after for a variety of reasons. The questions from individual investors may be “can I do a 1031 exchange”. It depends on many things including planning and patience.
By Al DiNicola, AIF®, CEPA ™
July 24, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
After owning a second home for a period of time the user (potential investor) may be seeking a way to sell the property, avoid paying capital gains (deferring capital gains) and move into another type of real estate. We will expand on the potential personal reasons for selling including seeking passive income.
During my real estate and investment advisory role I have lived in Hilton head Island, SC, Naples, FL , Sarasota FL as well as Cape Cod. All areas that have a variety of second home, vacation properties as well as primary residents. Many of the part time residents may not plan to rent their property. There are a variety of questions regarding how to position those properties for a 1031 exchange,
There is guidance provided by the IRS regarding 1031 Tax Deferred Exchanges of Vacation Properties & Second Homes. Not all the guidance that has been issues is straight forward and there is confusion on the possibility. In 2008 the IRS issue Revenue Procedure 2008-16 to clear up the confusion, sort of. Safe harbor language or guidelines that address vacation homes and second home conversion process into investment property would be the investor’s goal. Investment property would qualify for IRC § 1013 exchange treatment because it would be considered “qualified use”.
March 10, 2008, was the effective date or Revenue Procedure 2008-16. The caution would be the Revenue Procedure 2008-16 provided the language within the safe harbor. Why are you selling your Second Home or Vacation Home? There are numerous safe harbor guidelines on a variety of issues within section 1031. A Revenue ruling in 2004 addressed Delaware Statutory Trusts (DSTs). The guidance in Revenue Ruling 2004-86 would suggest the investor can enter into and complete a 1031 exchange utilizing a DST.
Why are you selling.
There are many reasons for selling your home. In today’s real estate market many areas have experienced increased valuation and despite the increase in interest rates there are plenty of cash and foreign buyers who may have an interest. The other reason may be that the second home or vacation property is too hard to manage from a distance, investors are getting older (baby boomers see past article) and investors may want to move into a more passive ownership role and receive passive income. Since 2004 DSTs have provided that alternative.
Requirements are strict.
The 1031 Exchange Tax Deferred process has a variety of requirements. Any requirements that are not met will disqualify any traditional exchange. Operating within the guidance for vacation property or a second home may enable the investor to qualify for the tax treatment of the 1031 exchange process. What are the guidelines Safe Harbor Guidelines for Vacation Homes or Second Homes Held as Relinquished Property. The main question from investors would be how the sale of the vacation home being sold may be included in a 1031 exchange.
Plan you course of action.
- Ownership of the second home or vacation property potentially involved in a 1031 exchange (the subject property or relinquished property) should be owned by the investors for 24 months. This period of time is known as the “qualifying use period”. That means if you owned your property for 8 years you need to retain for another two years as a rental.
- Rental requirements include the property must be rented at fair market value. The investors should have records that can reflect the property has been rented for a minimum period of 2 years before entering into the sale and exchange. This includes claiming on your tax returns. Offering the property for as a rental and then for sale must happen.
- The Rental Period for the property must be for a period of 14 days (or more) during the period of the two (2) years.
- Personal use is restricted. This may be where the investors needs to pay special attention. The investor can only use the second home property for a period of 14 days during each of the 2 years. . There is also another calculation regarding personal use. If the property was rented for 9 months of the year (270 days) then the investor may use the property for ten percent (10%) of the 270 days or 27 days.
- Not so friendly friend and family members may request time in the second home. If the investor provides use to family members, this is considered personal use and will count against the personal time. Any discounted rents charged to family members or other parties will also be regarding as personal use.
Learning from investors and CPAs
We are fortunate to interface with countless investors, CPAs, and other advisors. We always enjoy learning new strategies even after four decades of real estate and securitized real estate investments. A few years ago, we had an interesting conversation with a property owner in Naples, Florida.
- The property owner and her husband purchased a beach front property for $1M in the late 1990s. During their ownership they made capital improvements to the home that is known as adding to the basis of the home.
- As the years went by the couple decided to travel. They had another property in the mid-west and grown children (and grandchildren)around the country. Rather than leave their beautiful beach front home in Naples sit unoccupied they rented the home for six (6) months out of the year.
- The rent and rental of the home was reported on their personal income taxes for years. The property served a dual use. The husband passed away and the wife (then in her 80s) decided to sell the home. The wife wanted to down size and move into a home that had less upkeep.
- The home was listed for sale and sold within two (2) years. The home sold for about $12 million after 20 plus years of ownership and 8 years of being rented.
- Under the guidance of their CPA (and with out any input from use since we do not provide tax advice) the sale was bifurcated into two parts: a personal residence sale and an investment sale.
- $6M was accredited to the personal residence and $6M to the 1031 exchange.
- Upon closing the $6 M credited to the residential sale utilized the basis of the purchase $1M plus the capital improvements (adding a pool, expanding the home, etc.) that added to the basis. The owner utilized the $500,000 exemption provided by IRC §121 to arrive at a net selling price that was subjected to capital gains. Selling the property within two years of her husbands death qualified for the full $500,000 exemption.
- The investment sale utilized a 1031 exchange. $6M was directed by the closing agent to the Qualified Intermediary to be utilized in a 1031 tax deferred exchange.
- The wife now was free to invest into other investment properties (many passive income) providing her an income streams similar to what she was accustomed to when renting her home for 6 months.
- We cannot opine that this strategy will work for all investors in all situations. However, with the increase in many investors’ personal residences and the IRC §121 is limited to $500,000 for married couple investors are seeking other strategies. Remember there are safe harbor requirements for real estate and typically in revenue rulings.
As always- proceed with caution.
As we always mention we are not permitted to provide tax advice and that is their responsibility of the investor’s CPA. Every transaction must be suitable to individual investors. Referencing Revenue Proceeding 2008-16 may be a good starting point for your CPA to start providing insight.
DSTs are not for all investors.
The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email firstname.lastname@example.org.
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