A 1031 exchange both forward and reverse are powerful tools for real estate companies focused on vacation rentals. It allows investors/owners to sell investment properties and use all the proceeds to purchase new investment properties while deferring taxes associated with the sale. To qualify as an exchange, the relinquished and replacement properties must be qualified as “likeinkind” properties and the transaction must be properly structured as an exchange. “LikeInkind” relinquished properties and replacement properties must be real properties that have been and will be held for productive use in the investor’s trade or business or for investment, but there is some flexibility and gray area. For vacation rentals, as long as you follow the special definition of vacation rentals, you can apply other investment properties as “LikeInKind”.
There are many advantages to structuring your transaction as a 1031 Exchange, but for vacation rentals these are the most relevant:
- Defer taxes (up to 35-40% of the gain) on the sale of an investment property that can be applied to the transfer of a new property
- Overcome diminished depreciation rates by replacing the property
- Purchase a larger or better suited home
- Move an owner of investment properties into a vacation rental portfolio
- Assist in estate planning for heirs
There are rules specifically for the definition of what is considered a vacation rental property:
- The exchanged property must have been owned by the owner for 2 years
- The property must have been rented at least 14 days per year at fair market value
- The property was not used for more than 14 days or 10% (whichever is greater) of the rental use during each of the 2 years (for example, if the unit was rented 300 days, the owner could only reside in it for 30 days)
How does the forward 1031 process work?
- The owner (exchanger) signs a contract to sell a relinquished property to a buyer.
- The exchanger enters into the exchange agreement to do a 1031 with a qualified intermediary.
- At the closing of the relinquished property, the exchange funds are wired to the qualified intermediary.
- The exchanger has a maximum of 180 days in the exchange period (or until the tax filing. deadline, including extensions, for the year of the sale of the relinquished property) to acquire a replacement property of equal or more value.
- The exchanger must identify possible replacement properties (up to 3 of them) in writing within the 45-day identification period. In most cases the exchanger should have this replacement property in mind prior to the relinquished property sale.
- Multiple properties may be acquired to generate the equal to or greater status.
- The exchanger signs a contract to purchase the replacement property.
- At the closing of the replacement property, the qualified intermediary wires the exchange funds to complete the exchange.
- The exchanger files form 8824 with their tax return.
The real advantage to 1031 is for an owner of an investment property to exchange it for a vacation rental property. The new property would fall into the above rules for 2 years.
There is a reverse 1031 program which allows the owner to buy the vacation rental and then sell their investment property. Here is how the reverse exchange process works:
- As early in the process as possible, engage a Qualified Intermediary to create an Accommodation Titleholder (EAT) to facilitate your reverse exchange.
- Include an “Exchange Cooperation Clause” as an addendum to the purchase and sale agreements on both the relinquished property and the replacement property.
- Contact your tax and/or legal advisor as early in the reverse exchange process as possible to determine the advisability of completing a reverse exchange
- Contact the qualified intermediary immediately after entering into the purchase and sale agreements for both the relinquished and replacement properties and on anticipated closing dates of each transaction.
- If the EAT is taking title to the replacement property and there is a third-party lender providing financing, the lender must be informed as soon as possible that you will be completing a reverse exchange.
I would like to thank Patricia Flowers from IPX1031 a Fidelity Company for her information and detail. Should you have any questions or like to facilitate a 1031 for one of your clients she can be reached at