The key to legal and acceptable 1031 exchange activity is having the right timing and being clear about all the requirements up front. Especially with Congress considering the future of 1031 exchanges right now, it's a good idea to network with a qualified intermediary to determine the next steps for you. Being deliberate and measured in your approach is important to complying with the requirements and gaining all the possible benefits of moving forward with 1031 exchange.
One of the most common questions about 1031 exchanges has to do with primary residences or vacation homes. It is important to know that you can convert a primary residence into a vacation home in a way that meets 1031 guidelines, but this property must be rented and not just held. The property needs to be rented for some time and must be rented the majority of any year. If the property is not being used for investment or business purposes, technically it does not qualify for a 1031 exchange.
If you were to move forward with an exchange and discover later that the property was not the right fit, you would be responsible for paying the capital gains taxes. This is why the understanding and selection of the right properties is important from the outset.
If a 1031 is done on a primary residence that has been converted to a vacation rental, the Safe Harbor rule comes into play. This means that the new home has to be rented more than 14 days in each of the two years preceding the date of acquisition. This also means that you cannot live there more than 14 days of each year, or more than 10 percent of the total number of rental days for that property.
Make sure that you are clear about these rules and that you have engaged a qualified intermediary as soon as possible when you are ready to move forward with the exchange. The qualified intermediary is the third party who accepts the funds from the sale of the first property and holds them on your behalf until they are used to purchase the second property. It might seem like a minor detail, but it is very important that you use a qualified intermediary for your exchange. It not only ensures that you have followed the rules to the letter, but it can also be very helpful to have an experienced professional walking you through the process.