Before you sell your aging income property, consider swapping it for a vacation home in a like-kind real estate exchange.

Put simply, a 1031 exchange is IRS-speak for swapping one income property for another.  It’s a unique tax benefit—with some specific requirements—that’s becoming more common in real estate deals as property owners increasingly look to trade up for vacation homes.

In 1031 exchanges, you’re changing your investment in the eyes of the IRS; transferring the gain from one property to another, while allowing your investment to grow tax deferred.  If you qualify for a 1031 exchange, you’ll defer paying taxes on the sale until you sell many years later.  And since there are currently no limits to how many times you can 1031 your property, that might be a while.

One of the best ways to increase the value of your income property investment is to 1031 it into something better, like a vacation rental home.  Before you sell your income property, first see if you qualify for a 1031 exchange.

Here’s what you need to know:

1. Buying a vacation home with 1031 exchange proceeds

Rolling the proceeds of an investment property sale into a vacation rental enables you to increase the value of your investment while acquiring property you can enjoy and be proud of.  So long as your target property is rented for more than 14 days per year, and you use it for fewer than 14 days per year—and no more than 10% of the nights rented—you can invest the proceeds of a like-kind exchange into a vacation rental home.

2. Buying a retirement home with 1031 exchange proceeds

Say you own an aging fourplex, and you’d rather own an oceanfront home you can retire to one day.  If you simply sell the fourplex, you’d pay capital gains on any appreciation, as well as the depreciation recapture.  Alternately, you could use a 1031 exchange to purchase the perfect retirement home.  In the first two years, your personal usage cannot exceed 14 days, and you’ll need to rent it for 10 times the number of personal use nights: at least 14 days per year.

Converting rental property acquired in a 1031 exchange to a primary residence blends Section 1031 with Section 121 that provides the $250,000/$500,000 exclusions.  To benefit from Section 121, the converted property must be held for five years, with the first two as a rental also known as non qualified use.  At the end of five years, 3/5 of the gain is excluded given the $250,000 or $500,000 limits in Section 121.

3. Selling a vacation home through a 1031 exchange

You can sell your vacation home through a 1031 exchange, so long as you rented it for more than 14 days per year and your personal use was no more than 14 days per year (and less than 10% of the total nights rented) over the two years leading up to the sale.  Not yet renting your second home? 

4. Working on your home for "free" nights (and maximizing return on the rest)

Do you enjoy working on homes, or have plans to make improvements?  Any days you spend working on the vacation rental property don’t count against the 14-day limit.  That means, you can stay at your new beach house whenever you want as long as you’re putting in some elbow grease to improve its value.

5. Rates and fair market value

When renting a vacation home you purchased as part of a 1031 exchange, remember that your rates must be at fair market value.  No renting it to your sister for $1 per night—that would count as personal use unless she’s repairing the roof. 

Swapping your income property for a vacation rental home, as part of a 1031 exchange, is a personally rewarding way to level-up your investment.  You’ll also likely benefit from substantial appreciation, as many vacation markets are inherently constrained.  They aren’t building more ocean!