Can You 1031 Exchange into a Short-Term Rental?

What a 1031 exchange does

A 1031 exchange lets you sell investment or business real estate and buy other real estate without paying tax on the gain at the time, as long as you follow the rules. The tax is deferred, not forgiven.

The basics, from the IRS instructions for Form 8824:

• Real property only. Since 2018, section 1031 applies only to exchanges of real property. Furniture and equipment in a furnished rental are not part of the like-kind exchange.
• U.S. for U.S. Real property in the United States and real property outside the United States are not like-kind.
• Investment or business use on both sides. The property you sell and the property you buy must both be held for productive use in a business or for investment.
• Cash is taxable. If you receive money or other property that is not like-kind, gain is recognized to the extent of what you receive.
• Report it. You file Form 8824 with your return for the year of the exchange.

The question for a short-term rental is the third point. A beach house or lake cabin can look a lot like a personal vacation home, and the IRS does not allow exchanges of personal homes.

Why vacation homes get extra scrutiny

The IRS treats a home used only for personal purposes as outside section 1031, even if you expect it to go up in value. Rev. Proc. 2008-16 cites the background:

• Rev. Rul. 59-229 concluded that gain from exchanging personal residences cannot be deferred under 1031.
• Rev. Proc. 2005-14 states that 1031 does not apply to property used solely as a personal residence.
• Moore v. Commissioner (2007): a couple exchanged one lakeside vacation home for another. Neither home was ever rented. The Tax Court held the homes were held for personal use, and that the "mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence."

A working short-term rental, booked by guests most of the year, is very different from the Moore homes. But because many owners rent a home and also use it themselves, the IRS created a safe harbor to settle the question.

The safe harbor for short-term rentals

Rev. Proc. 2008-16 says the IRS will not challenge whether a dwelling unit qualifies as investment or business property if it meets set use standards. A dwelling unit is real property with a house, apartment, condominium or similar improvement that has sleeping space, a bathroom and cooking facilities, which describes nearly every vacation rental.

Two points are easy to miss:

• The test runs year by year. Each of the two 12-month periods has to pass on its own. A light first year cannot be averaged with a busy second year.
• It is a safe harbor, not the only path. The procedure covers only whether the home counts as investment or business property. You still have to meet every other 1031 requirement, and an exchange outside the safe harbor is judged on its facts, which is a harder argument to make.

What counts as personal use

Personal use is broader than the days you sleep in the house yourself. The safe harbor uses the personal-use definition in section 280A, and IRS Publication 527 explains it. A day counts as personal use when the home is used by:

1. You or any other person who owns an interest in it.
2. A member of your family or of another owner's family, unless that person uses it as their main home and pays a fair rental. Family means your spouse, siblings, half siblings, ancestors and lineal descendants.
3. Anyone under an arrangement that lets you use some other dwelling unit, such as a swap with another owner.
4. Anyone paying less than a fair rental.

Publication 527 also explains what does not count: a day you spend working substantially full time repairing and maintaining the property, not improving it, is not a personal-use day, even if family members use the home for fun that day.

Deadlines and mechanics

A 1031 exchange into a short-term rental runs on the same clock as any other exchange, and missing a date usually ends the deferral. From the IRS instructions for Form 8824:

Practical points for short-term rental buyers:

• Shop before you sell. Forty-five days is short when good vacation rental markets have thin inventory. Know your target market and price range before the sale closes.
• Check the rules in the new market. Many cities and counties require permits or limit short-term rentals. A home you cannot legally rent cannot pass a rental test. See what owners should check about permits.
• Run the numbers on the rental, not the tax savings. The deferral is worth little if the home loses money. Model bookings, nightly rates and costs with our vacation rental income calculator and deal analyzer, and read how to analyze a short-term rental deal.

Common mistakes and downsides

Most failed exchanges into vacation rentals come down to timing, personal use or a weak deal. The mistakes to avoid:

• Treating the new home as the family's vacation house. For two years, family use is capped. If the real goal is a second home for the family, a 1031 exchange may be the wrong tool.
• Pricing below market for friends and family. Days rented below a fair rental count as personal use, and they do not count toward your rental days.
• No records. The safe harbor is a count of days. Keep booking records, payout statements and a personal-use log for both 12-month periods.
• Taking cash out at closing. Any money you receive is taxable to the extent of your gain.
• Forgetting the furniture. Since 2018, only real property qualifies. Furnishings bought for the rental sit outside the exchange.
• Expecting a big first-year deduction. If you also plan to use the short-term rental tax loophole or a cost segregation study, ask your CPA how the exchange affects the basis you can depreciate. A deferred gain carries into the new property's basis rather than disappearing.
• Breaking the rules after you file. Rev. Proc. 2008-16 says that if you report an exchange expecting the replacement to qualify and it later does not, you should file an amended return, if necessary, and not report it as a 1031 exchange.

A short-term rental also asks more of an owner than a long-term rental: guest messages, cleaning between stays, pricing and repairs. If you plan to hire help, our owners page explains how we manage homes, and our guide to self-managing or hiring a manager covers the trade-offs honestly.

The bottom line

You can 1031 exchange into a short-term rental, and the IRS safe harbor shows how: own it at least 24 months after the exchange, rent it at a fair rental for 14 days or more in each of the two years, and keep personal use within the greater of 14 days or 10% of rented days, counting family and discounted stays as yours. Meet the 45-day and 180-day deadlines, take no cash, and keep a day-by-day log. This is general information, not tax, legal or investment advice, so bring a CPA and a qualified intermediary in before you sell.