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NO LIKE-KIND EXCHANGE FOR GEORGIA VACATION HOME

May 31, 2007

The tax law allows you to skip taxes on up to $500,000 of gain when you sell a "principal residence." That usually doesn't cover a vacation home -- a distressing technicality, because for many owners, the resort cottage has appreciated much more than the city house.

That leads taxpayers to try to qualify for the other big real estate tax break - the "like-kind exchange." But these "Section 1031" deals have some technicalities of their own, as a Georgia couple learned yesterday in Tax Court.

Barry and Deborah Moore bought lakefront property in Georgia on Clark Hill Lake back in 1988. Ten years later they wanted a property on Lake Lanier. Working with an escrow agent, they sold the Clark Hill property and used the escrowed proceeds to buy the Lake Lanier place; they reported the deal as a like-kind exchange on their 2000 return, paying no tax on ten years worth of appreciation.

NOT 'HELD FOR INVESTMENT'

The IRS said that the exchange failed to meet one of the requirements of Section 1031:

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

The Moores didn't run a business out of the lake home, so they had to show that they held the property "for investment." Their argument apparently was that the resort properties were going up in value, so they were good investments. The Tax Court said that didn't cut it:

Petitioners point to their interest in the appreciation potential of the Clark Hill and Lake Lanier properties, both before and after acquisition, and argue: "If investment intent is one motive for holding * * * property, it is held for investment for purposes of Section 1031." Petitioners' argument, if carried to its logical extreme, is that the existence of any investment motive in holding a personal residence, no matter how minor a factor in the overall decision to acquire and hold (or simply to hold) the property before its inclusion in an exchange of properties, will render it "property * * * held for investment" with any gain on the exchange eligible for nonrecognition treatment under section 1031. Petitioners are mistaken. It is a taxpayer's primary purpose in holding the properties that counts. (emphasis added)

The Tax Court noted caselaw holding personal use of property isn't compatible with treating it as "held for investment" under Section 1031. The court quoted the well-known Starker case:

It has long been the rule that use of property solely as a personal residence is antithetical to its being held for investment. Losses on the sale or exchange of such property cannot be deducted for this reason, despite the general rule that losses from transactions involving * * * investment properties are deductible. A similar rule must obtain in construing the term "held for investment" in section 1031.

The court pointed to the taxpayers' use of the houses as vacation homes, their failure to rent either the old or the new property, and the personal improvements they made as evidence that the homes were for personal use, rather than for investment:

Petitioners would have us believe that they used the house only as a caretaker's cottage while awaiting the expected appreciation in the value of the property as a whole. While awaiting that event, however, they purchased a 6-to 8-passenger motorboat to pass the time on the lake.

Ouch.

In short, the evidence overwhelmingly demonstrates that petitioners' primary purpose in acquiring and holding both the Clark Hill and Lake Lanier properties was to enjoy the use of those properties as vacation homes; i.e., as secondary, personal residences.

Needless to say, the Moores lost the argument, and the Tax Court said the exchange failed the Section 1031 requirements.

The Moral? If you have any hope of qualifying a vacation home as "like-kind" property, you need to stop using it some years before it's time to sell. You need to start renting it out, to maintain it as a rental place, and to report income and loss from the property on your Schedule E. And by all means, don't keep the boat there anymore.

Cite: Moore, T.C. Memo 2007-134.

UPDATE: The TaxProf has more.

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