Managing the 1031 Exchange Rules for Vacation Homes, Conversions and Mixed Use Properties

Financial Planning Dentist

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 taxpayer must have owned the property for the two years immediately prior to the sale and:

  1. For each of the years, the property must be rented to a person for 14 days or more
  2. The taxpayer’s personal use has to be limited to no more than 14 days per year or less than 10% of the days per year that property is rented.

Rules for Converting a 1031 Exchange Property to a Personal Residence

If the taxpayer’s intent, based upon facts and circumstances at the time of the property acquisition was to hold the property as an investment or for use in a business, the subsequent conversion use of the property to use as a principal residence should not otherwise jeopardize the ability to exchange.  As an example, a taxpayer may wish to exchange into a rental condominium in Florida and upon retirement relocate from a northern state into the condominium as the principal residence.

If the taxpayer subsequently sells the principal residence, there may be the ability to defer the gain under §121.  However there are some limitations to this deferral upon conversion, otherwise, taxpayers might convert exchange property into a principal residence property, sell shortly thereafter, and seek IRC Section 121 primary residence deferral.  These rules require that the property has to be held for at least five years in total with the period of time the property was held as an exchange property included.  The period of time the property was used as an exchange property needs to be backed out of the calculation for the principal residence use deferral.  This calculation is made by using the period of time the property was held as an exchange property as the numerator and the period of time the property was held in total as the denominator.  The resulting fraction or percentage would be applied to the total gain and the resulting dollar amount would not be eligible for a §121 deferral. 

Take the example of a property owned by a taxpayer for seven years prior to sale, three of which were used as an exchange property and four of which were used as the taxpayer’s principal residence.  Assume that the gain upon sale is $200,000.  Dividing the number of three years by seven years x $200,000 results in the amount of $85,714 which is taxable.

1031 Exchanges and Mixed-Use Properties

At times, a taxpayer may own a home as the principal residence but part of the property may have been used as an investment or in connection with a business or trade, creating an exchange eligible component.  This is known as a mixed-use property.  An example might be a psychologist who sees patients in a home office.  Another example might be a property with a separate coach house that is rented out.  It is quite common for a taxpayer to sell a three-flat where the taxpayer uses one unit as the principal residence.  In these instances IRC Section 121 and IRC Section, 1031 can both be used to achieve total deferral.    

There is one caveat with exchanges of mixed-use properties, which is that on closing statements there is a tendency to give credits for prorated rent and security deposits to the buyer.  This causes the net amount of proceeds attributable to each property use component to be reduced proportionately.  Technically, those credits only pertain to the exchange eligible portion of the property and should not appear as a credit on the personal residence portion of the sale.


A variety of circumstances surround the property that has been or will exchange eligible and may also have been used or will be used by the taxpayer as a principal residence or vacation home.  Revenue Procedure 2008-16 provides rules regarding vacation homes and exchange eligible property.  Likewise, there are rules under IRC Section 121 for converting exchange property into a personal residence and vice-versa.  Properties that have both a principal residence component as well as an exchange-eligible one can benefit from both the deferral sections, but care should be taken to do proper accounting so that buyer credits affect the exchange eligible portion of the sale only.

More related articles:

Understanding the Deferred Property Sale Agreement: A Win-Win for Sellers

Selling a property is a significant decision that involves numerous considerations for both the buyer and the seller. While the traditional method of immediate payment is prevalent, some sellers opt for more flexible arrangements. One such option gaining popularity is the Deferred Property Sale Agreement. This article delves into what this agreement entails and highlights the benefits it offers to the seller. What is a Deferred Property Sale Agreement? A Deferred Property Sale Agreement, also known as a “seller financing” or “owner financing” agreement, is a unique arrangement where the property seller acts as the lender to the buyer. In this scenario, the seller agrees to receive the purchase price in installments over an agreed-upon period instead of the buyer paying the entire sum upfront. How Does it Work? Negotiating Terms: The buyer and seller negotiate the terms of the agreement, including the property’s sale price, the down payment (if any), the interest rate (if applicable), the length of the payment period, and other relevant conditions. Promissory Note: Once both parties agree on the terms, they execute a promissory note that outlines the specific conditions of the arrangement, including the payment schedule and any penalties for default. Title Transfer and Collateral: While the buyer assumes possession and benefits from the property, the seller retains the title as security until the final payment is made. This acts as collateral, protecting the seller’s interests. Monthly Payments: The buyer then makes regular monthly payments to the seller, which typically include both principal and interest, as they would with a traditional mortgage. Closing Costs: Closing costs and administrative fees can be negotiated between the parties, although it is common for the buyer to bear these expenses. Benefits to the Seller: Access to a Larger Pool of Buyers: By offering seller financing, the seller opens the door to a wider range of potential buyers. This is especially beneficial in a slow market or when the property might not be attractive to traditional bank-financed buyers due to specific circumstances. Faster Sale: A Deferred Property Sale Agreement can expedite the selling process. Without the need for a bank’s approval, the transaction can be completed more swiftly, allowing the seller to liquidate their property faster. Interest Income: The seller stands to earn interest on the financed amount, potentially leading to a higher overall return on investment than if the property was sold outright. Secure Monthly Income: The seller enjoys a predictable cash flow from the monthly installments, providing a steady income stream over the payment period. Flexibility in Negotiations: Sellers have the freedom to negotiate various terms, such as interest rates and payment schedules, based on their financial needs and preferences. Reduced Tax Liabilities: By spreading the income from the sale over several years, the seller may benefit from lower tax liabilities, compared to a lump-sum payment that could push them into a higher tax bracket. Lower Marketing Costs: In some cases, seller financing allows the seller to save on marketing expenses, as the property’s unique payment terms can attract motivated buyers. A deferred Property Sale Agreement can be an advantageous option for sellers seeking greater flexibility and a potentially faster sale. By offering seller financing, sellers can access a broader pool of buyers, earn interest income, and secure a predictable monthly cash flow. As with any financial arrangement, it’s essential for both parties to conduct due diligence and seek professional advice to ensure the agreement meets their respective needs and complies with relevant legal requirements.

Read More »
Peter Locke

The Rich Man’s Roth

Life Insurance…. Let me guess, was your first thought, “are you serious?” If so, don’t worry mine was too. How could life insurance be like anything like a Roth? When I was first presented with the idea that life insurance was more than purchasing protection about five years ago, being a CFP®, I immediately thought the same thing, this can’t be right. I mean outside of a few cases like when individuals have a high need for income protection being the primary breadwinner of the family, paying estate taxes, paying off debt and future obligations with a death benefit, or using it as a gifting strategy to avoid the estate tax exclusion (for the ultra-wealthy), I didn’t think there was more. I knew a lot of people needed it but I just thought most people would get term life insurance and call it good. It wasn’t until I spoke with a CPA and one of the leading tax attorneys in the country on multiple zoom calls, thanks Covid, where everything I thought about life insurance was flipped upside down. I think many people were and maybe still are in the same position as I once was years ago. I am here now to tell you that permanent life insurance might be one of the best-kept secrets that the ultra-wealthy have been using for decades to get tax-free income, leverage, income protection, and asset protection. Now there are a million ways to design life insurance but I want to share with you on a high level how some of the policies we design work and why it might be something that would complement the rest of your portfolio. As a financial planner, I want my clients to have a wide variety of different income streams, strategies, and ways to grow their wealth. Life insurance, I believe, was the piece I have been missing in our InSight-Full® Plan. My goal for every client is to help them reach their goals by maximizing how each dollar is used both now and in the future by simplifying each part of their financial lives. This means finding which accounts should be funded, when, how, and then how to withdraw from them when you need them. So why is life insurance so great? For the right person and situation, some types of permanent life insurance policies can provide individuals a mix of growth, protection, tax-free income, and additional leverage should they choose to use it. Let’s start with growth. Whether you’re using a universal life policy that’s tied to an index (think SP500) or ownership in an insurance company (think of a dividend payout) clients can accumulate wealth inside of a policy that’s providing them protection. As the money grows, the death benefit can also increase which means more of a payout to beneficiaries. In some types of insurance like whole life, cash accumulates (cash value) similar to that of a bank account. As that money accumulates, policy owners can withdraw that money and pay interest back to the insurance company. The beautiful part about this is the dividends paid by the insurance company for owning whole life insurance can be more than the interest being charged (leading to a positive arbitrage). Second, since most individuals use life insurance for asset protection and income protection for a certain amount of time (term insurance), permanent life insurance gives you this protection for life. Unlike term insurance, where once you reach the end of your term your coverage ends and there is no value remaining, permanent life insurance continues giving you the flexibility to use the cash value accumulated for almost anything you want. So whether you take out a loan and use that money to make other investments or you annuitize your cash value into an income stream, having permanent life insurance can provide you more value in my opinion than term insurance in the long run due to its cash value. Permanent life insurance can be used as a tax-free income generator as well. Every premium that is paid earns dividends and interest. As that money grows and compounds over time, you end up with a nest egg of cash value. This cash value can be annuitized into a tax-free income stream for life (all growth inside the policy is tax-free) with distribution rates as high as 6-7%. Outside of a Roth IRA and Municipal Bonds, tax-free income is hard to come by. Tax-free income that also pays out a death benefit to beneficiaries is a win-win for everyone. Lastly, some insurance companies allow life insurance to be used as collateral for a loan making permanent life insurance one of the most flexible and lucrative vehicles out there. So whether you’re looking for income and or asset protection, tax-free income in retirement, leverage, or coverage for estate taxes, permanent life insurance is a great place to look. Keep in mind, not all insurance policies are created equal and provide the same features so you need to make sure to do your due diligence, talk with a professional, to make the best decision for you and your family.

Read More »

Pin It on Pinterest