1031 Exchanges on Airbnb Rental Properties

Airbnb rental properties are becoming more and more common every day. These popular vacation home properties are used as a second source of income in many cases or as an exchange from more demanding business properties like those in the agricultural industry. Airbnb properties are eligible for a 1031 exchange and can be found all over the country, from Oregon to New York. As a result, it is common for clients to call a qualified intermediary, like Accruit  with 1031 exchange questions regarding sales of their former or future principal residences or vacation homes.

For example:

• Under what circumstances can these dwellings be used as part of a 1031 tax deferred exchange?

• Do they satisfy the requirement that both relinquished and replacement properties be held for investment or use in a business or trade?

•  Does some personal use trump the investment use of the property?

Rules for Including a Vacation Property in a 1031 Exchange

Historically, determining whether a home that was both rented out and used by its owner could be eligible for 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 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 before the exchange. Additionally, within each of the two 12-month periods before the sale, the property must be rented at fair market value to a person for at least 14-days.. The taxpayer cannot have used the property personally for the greater of 14-days, or 10% of the number of days in the 12-months that tenants had rented it.  

The requirements for a property to qualify as a 1031 replacement property are  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 for at least 14-days. The taxpayer cannot use the property personally for the greater of 14-days or 10% of the number of days in the 12-months the property had been rented. The taxpayer can use the relinquished or replacement property for additional days if the use is for property maintenance or repair.

1031 Exchanges and Mixed-Use Properties

At times, a taxpayer may own a home as the principal residence. Still, part of the property may have been used as an investment or connected with a business or trade, creating an eligible exchange 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 cabin in Oregon with a separate coach house that is rented out via Airbnb or another vacation rental site. It is common for a taxpayer to sell a three-flat where the taxpayer uses one unit as the principal residence. In these instances, §121 and §1031 can both be used to achieve total deferral. There is one caveat with exchanges of mixed-use properties. There is a tendency to give credit for prorated rent and security deposits to the buyer on closing statements. This causes the net amount of proceeds attributable to each property use component to be reduced proportionately. Technically, those credits only pertain to the eligible exchange portion of the property and should not appear as a credit on the personal residence portion of the sale. 

In sum, a variety of circumstances surround a property that has been or will be eligible for 1031 exchange and may also have been used or will be used by the taxpayer as a principal residence or vacation rental home. Revenue Procedure 2008-16 provides rules regarding vacation homes and exchange eligible property. Likewise, there are rules under IRC §121 for converting exchange property into a personal residence and vice-versa. Thus, properties with both a principal residence component and an exchange-eligible one can benefit from both the deferral sections. Still, care should be taken to do proper accounting so that buyer credits affect the eligible exchange portion of the sale only.