Converting 1031 property into a property for personal use

Consider selling your business or investment property in a 1031 exchange for a house in the country, a condo on the coast or a cabin in the woods. You must purchase the replacement property for business or investment use, but you can do this by renting the property for 14 or more days per year and with specific limitations you can use the property as a vacation home.
The IRS recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes. Rev. Proc. 2008-16 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.

Under Rev. Proc. 2008-16, the Service will not challenge whether a dwelling unit qualifies under Section 1031 as property held for investment or held for productive use in a trade or business, if the qualifying use meets the following standards:

(a) The dwelling unit is owned by the taxpayer for at least 24 months immediately after the exchange (the “qualifying use period”); and

(b) Within the qualifying use period, in each of the two 12-month periods immediately after the exchange,

(i) The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and

(ii) The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental

The taxpayer should acquire the investment property with the intention of meeting such standards. Subsequently, a taxpayer may reassess their use of the replacement property. For example, in year three, after successfully meeting the parameter of Rev Proc 2008-16, the taxpayer may decide at such time to cease renting the property and convert the property to a primary residence or vacation home. At that time, the exchange transaction is well past and the taxpayer has established their investment intent and the conversion of use in the property should not create tax risk. Furthermore, in the situation the property is converted to a primary residence, there is an opportunity to benefit from IRC 121, the primary residence exemption, upon sale after establishing meeting such criteria.