Vacation Homes As Part Of A 1031 Exchange? - Oahu Real Estate Blog

Summary:

A 1031 exchange is a terrific tool to defer capital gains taxes and build wealth with real estate.
Personal residence? Investment property? – Vacation homes can be hybrids. Know how you can maximize your tax benefits.
A vacation home 1031 exchange could be an opportunity to get what you want. Know how to successfully exchange vacation homes, defer capital gains taxes, and eliminate HARPTA & FIRPTA tax withholdings.

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— Last week, I received a phone call: “Could I use a 1031 exchange to sell my Virginia home and buy a Hawaii property?”

Yes, of course, you can. As long as the relinquished home and the replacement home are both investment properties.

A 1031 exchange is one of the finest gift horse opportunities to build substantial wealth by deferring capital gains taxes when selling an investment property and buying another investment property.

To understand 1031 exchanges’ benefits, requirements, and restrictions, review our article: Climbing The Wealth Ladder With A 1031 Exchange.

But a 1031 exchange can only be used for investment properties, and not for your principal residence, or your 2^nd home held for personal use.

The IRS differentiates between two types of properties based on their usage:

A personal residence – for personal use and enjoyment. This is your principal residence or your 2^nd home. It comes with some tax deductions, which get reported on Schedule A of your tax return.
An Investment property – held for the business of making money. It comes with many more tax deductions, which get reported on Schedule E of your tax return.

You get many more tax benefits with owning an ‘investment property,’ ..lots more.

See related article: Real Estate Tax Benefits – The Ultimate Guide

“Life’s true gift lies in your freedom to design it beautifully. You get to chase the opportunity to fill your days with meaning—to live your life the way you choose.” ~ Jim Rohn

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What About Vacation Homes? – They Are Hybrids!

More common than not, plenty of Hawaii vacation homes serve a clever dual purpose for both, personal use, and as an investment for the business of making money.

Here it can get confusing what is considered ‘personal use’ versus ‘ investment.’ That’s why the IRS spells out precisely where the dividing line is.

You must know and follow the rules. Otherwise, the IRS could deny the deductibility of your expenses. And, in the case of a 1031 exchange, you could lose the benefit of the entire tax deferral. – Oops.

Two Tests To Qualify Your Vacation Home As An Investment Property

For the IRS to allow you to claim the enormous tax benefits available for investment properties, your vacation home must pass two tests:

Test 1: — Personal use of the investment property cannot exceed 14 days, or 10% of the number of days rented at fair market rent, whichever is greater. Personal-use days are days when you, your family, and or friends use the property unless they pay fair market rent!

Test 2: — You must rent at fair market rent. Any ‘good tenant discount’ and or ‘family & friends discount’ cannot be greater than 20% of the fair market rent. 20% discount is the borderline danger zone. That’s why tax advisors typically recommend you shouldn’t discount beyond 10%. Always document fair market rent values in case you get audited.

You may review the details in our article:

‘Personal Use’ Of Your Hawaii Vacation Rental – Tax Considerations

If your vacation home does not pass both tests, then you could still split your vacation home expenses proportionately based on the time usage. Personal use expenses go on Schedule A and investment use expenses go on Schedule E.

However, splitting expenses increases the risk to trigger an audit. Danger zone. Check with your favorite qualified tax professional and maintain impeccable records.

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**How To Qualify Your Vacation Home For A 1031 Exchange**

You are in luck. We are in the business of making your dreams come true. That’s why we write this blog and share with you tips and tricks that might help your decision process. Knowledge is power. It can open new opportunities and keep you out of trouble.

Do you own an investment property but would rather own a vacation home?
Do you own a vacation home but would rather own a more lucrative investment property?
Do you own a vacation home but would rather own a different vacation home?

In any case, there is an opportunity for you to use a 1031 exchange and successfully defer capital gains taxes with your vacation home.

The IRS ruling ‘Revenue Procedure 2008-16’ provides a safe harbor for 1031 exchanges involving vacation homes (more broadly referred to as dwelling units).

Certain conditions must apply:

Vacation Home – Relinquished Property

For your vacation home to qualify as a relinquished property in a 1031 exchange…

You must have owned the vacation home for at least 24 months immediately before the exchange (the “qualifying use period”); and
In each of the two 12-month periods immediately before the exchange, …
- You must have rented the property at a fair market rate for at least 14 days or more, and,
- You can not have used the vacation home for personal use for more than the greater of 14 days or 10% of the number of days during each of the 12 months that you rented the property at a fair market rate.

Vacation Home – Replacement Property

For your vacation home to qualify as a replacement property in a 1031 exchange…

You must own the vacation home for at least 24 months immediately after the exchange (the “qualifying use period”); and
In each of the two 12-month periods immediately after the exchange, …
- You must rent the property at a fair market rate for at least 14 days or more, and,
- You can not use the vacation home for personal use for more than the greater of 14 days or 10% of the number of days during each of the 12 months that you rent the property at a fair market rate.

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Personal Use Definition

Personal use includes use by the owner’s family members, brothers and sisters (by whole or half-blood), spouses, ancestors, and lineal descendants.

It also includes any other ‘friends & family’ arrangements where fair market rent is not paid.

Fair market rent considers all rights and obligations of the rental agreement including bartered or side benefits!

Exception: Family members’ use will not be considered “personal use” if the property is

rented at fair market rent, and
the family member uses it as their principal residence.

See related article: Buying A Home For Your Kids! – Renting To Relatives

Palm Trees seen from my Hammock - 2 hours later — Palm Trees seen from my Hammock – 2 hours later

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HARPTA & FIRPTA?

If you are lucky enough to make a 1031 exchange work with your vacation home, consider one more side benefit.

A successful 1031 exchange eliminates HARPTA & FIRPTA tax withholdings! That’s right. Otherwise…

HARPTA tax withholdings apply when you don’t live in Hawaii at the time when you sell Hawaii property. In addition,
FIRPTA tax withholdings apply when you don’t live in the US at the time when you sell your Hawaii property.

You may review the details in our article:

HARPTA & FIRPTA Tax Withholdings – Avoid The Pitfalls

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Conclusion:

The opportunity to defer capital gains taxes with a vacation home 1031 exchange is doable if you follow the rules.

But unlike splitting your property expenses proportionately on Schedule A (personal use) and Schedule E (investment), a 1031 exchange has a binary outcome. Either you succeed, or you fail in deferring the taxes.

Both outcomes are on the opposite ends of the financial spectrum. A failed 1031 exchange can result in a huge tax bill. Ouch.

The rules are simple, but not easy to follow. – Always maintain impeccable records.

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Contact us when you are serious and ready. We are here to help.

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Disclaimer: The author is an active real estate investor and a licensed real estate broker who has completed many 1031 exchanges. Hawaii Living is a real estate brokerage that assists countless real estate investors with growing their respective real estate portfolios. We are expert realtors, not tax professional advisers. For tax matters always check with your favorite qualified tax professional.