When considering whether a second home qualifies for a 1031 exchange, it's important to understand the criteria that the IRS uses to determine if a property is eligible for such treatment. Under Section 1031 of the Internal Revenue Code, the property must be held for productive use in a trade or business or for investment purposes. This means that the property should not be primarily for personal use, such as a vacation home or a second residence.

The IRS has provided guidance on this matter, particularly through Revenue Procedure 2008-16, which outlines the conditions under which a dwelling unit, such as a second home, can qualify for a 1031 exchange. According to this guidance, a dwelling unit may qualify if it meets the following criteria:

1. Ownership Duration: The property must be owned by the taxpayer for at least 24 months immediately before the exchange. This period is referred to as the "qualifying use period."
2. Rental Requirement: Within the qualifying use period, the property must be rented to another person at a fair rental for at least 14 days or more in each of the two 12-month periods immediately preceding the exchange.
3. Personal Use Limitation: The taxpayer's personal use of the property must not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the property is rented at a fair rental.

If these conditions are met, the second home can be considered as held for investment purposes, thus qualifying for a 1031 exchange.

Let's illustrate this with an example:

Imagine you own a lakefront property that you use as a second home. You have owned this property for several years and are considering exchanging it for another investment property. To qualify for a 1031 exchange, you ensure that over the past two years, you have rented the property out for at least 14 days each year at a fair market rental rate. Additionally, your personal use of the property has been limited to no more than 14 days each year.

You decide to proceed with the exchange and choose Deferred.com as your qualified intermediary. We facilitate the transaction by selling your lakefront property and holding the proceeds. You then identify a replacement property, such as a rental condo in a different location, within the 45-day identification period. We use the proceeds to acquire the replacement property on your behalf within the 180-day exchange period.

By adhering to these guidelines and using Deferred.com as your qualified intermediary, you successfully defer the capital gains tax on the sale of your second home, as it qualifies for a 1031 exchange under the IRS's criteria for investment properties. This strategic move allows you to reinvest in a new property while deferring taxes, optimizing your investment portfolio.