A friend of mine bouught a townhome years ago for a capital gain.
He let his son live in there for free. He paid foe every bill himself, not his son.
Now he is selling the townhome and buying a new house also for capital gain.
Is this townhome qualified as investment property to make this sell-buy transaction 1031 exchange?

Thank you for your help!
I appreciate it!

Technically, he could probably make the case that it qualifies for a 1031 exchange, if he could show that he "rented" the townhome to his son.

Morally and ethically, it does NOT qualify, as it is NOT a true rental or business property.

No, it does not qualify as investment property at this point in time. The IRS would recharacterize the house as a second home because the son paid no rent or expenses.

He could have treated it as investment property had he charged the son fair market rent, but unfortunately he didn't, or if he held the property without letting a related party stay in the house rent free.

However, we now have Revenue Procedure 2008-16 that covers this scenario. Vacation homes and second homes can now be 1031 exchanged if:

The property is owned for at least two (2) years
The property is rented for a minimum of 14 days for each of those two (2) years
The taxpayer's personal use of the property is limited to no more than 14 days each year or no more than 10% of the number of days that the property was rented