It is quite common for clients to call a 1031 exchange company with questions regarding exchanges of their former or future principal residences or vacation homes. After all, if you can have a rental property with some side benefits, it would be the best of two worlds, right? Well, we will discuss the requirements you should be aware of as you evaluate the replacements. So these are the questions imbedded in the 1031 Exchange requirements that must be answered:  Under what circumstances can these dwellings be used as part of a 1031 exchange? Do they satisfy the requirement that both the relinquished and replacement properties must be held for investment or for use in a business or trade? Does some personal use trump the investment use of the property? This article is intended to answer these commonly asked questions: Under what circumstances can a second home or vacation home constitute relinquished or replacement property for the purposes of a 1031 exchange? Can a principal residence be converted into an investment property eligible for 1031 tax deferral upon sale? Can a property that has been held for investment be converted to a principal residence and what are the rules when it is sold? Can a mixed-use property be sold with a personal residence exemption and 1031 exchange deferral? Rules for Including a Vacation Home in a 1031 Exchange Historically, determining whether a home that was both rented out and used by its owner could be eligible for a 1031 tax deferral was difficult to ascertain.  There was some case law but that was a bit inconsistent.  The IRS attempted to provide some definitive guidance regarding some of these questions in the form of Revenue Procedure 2008-16.  As the IRS aptly put it: “The Service recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes. In the interest of sound tax administration, this revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under §1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes.” This revenue procedure made clear that for a relinquished vacation property to qualify for a 1031 exchange, the property has to be owned by the taxpayer and held as an investment for at least 24 months immediately prior to the exchange.  Additionally, within each of the two 12-month periods prior to the sale, the property must have been rented at fair market value to a person for at least 14 days or more, and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented. The requirements for a property to qualify as a 1031 replacement property are very similar.  The property has to be owned by the taxpayer for at least 24 months immediately after the exchange.  Also, within each of the two 12-month periods after the exchange, the property must have been rented at fair market value to a person for at least 14 days or more and the taxpayer cannot have used the property personally for the greater of 14 days or 10% of the number of days in the 12-month period that it had been rented. The taxpayer is allowed to use the relinquished or replacement property for additional days if the use is for property maintenance or repair. These days and the project and maintenance completed should be documented thoroughly. Rules for Converting a Personal Residence for a 1031 Exchange In many cases, conversion of a personal residence to a property held as an investment or for use in a business or trade “exchange eligible property,” as defined above, may still allow a taxpayer to receive a full exemption of gain pursuant to the rules of Internal Revenue Code (IRC). The comprehensive set of tax laws was created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress and is sometimes also referred to as the Internal Revenue Title. The code is organized according to the topic and covers all relevant rules pertaining to income, gift, estate, sales, payroll, and excise taxes. Internal Revenue Code Section 121 upon sale of the property.  That Code section provides for an exclusion of gain of up to $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly upon the sale of a principal residence.  There is a requirement that during the five-year period immediately preceding the sale, the taxpayer must have used the property as a principal residence for a cumulative period of at least two years. Even if the property has had principal residence use followed by exchange eligible use, the taxpayer does not necessarily have to do an exchange on the investment/business use of the property if the total gain can be sheltered by the §121 allowed exclusions.  So even if during the immediate two years preceding the sale, the property was used as exchange eligible property, the taxpayer may still benefit from the personal residence exclusion.  In the event, the gain exceeds the maximums allowed for per IRC Section 121 primary residence, the taxpayer may still be able to shelter the balance via a 1031 exchange, thus combining the benefits of these two code sections. Under Revenue Procedure 2008-16 the conversion of the principal residence to an exchange eligible investment property does not disqualify a family member as the tenant.  However, the revenue procedure requires that this should be done at a fair market rental and it must constitute the family member’s personal residence and not the family member’s vacation home.  There are additional rules for the rental of the property by a family member who co-owns the property with the taxpayer. Should a taxpayer wish to convert the personal residence to exchange eligible property, the