Introduction

One of the core requirements of IRC section 1031 is that both the property disposed of in the exchange (the "relinquished property") and the property acquired in the exchange (the "replacement property") must be held by the taxpayer "for investment" or "in a trade or business."² This requirement clearly precludes tax-deferred exchange treatment for personal residences.³

Many types of property, including vacation homes, do not easily fit into either the "personal residence" or the "property held for investment" category.⁴ The Internal Revenue Code does deal with the tax treatment of vacation homes in limiting the deductions allowable as to properties which both are rented and used for personal use⁵. However, neither the Internal Revenue Code nor the regulations promulgated thereunder provide any guidance as to whether second homes or vacation homes are deemed to be held "for investment"⁶ and until recently, there have been no published cases on this issue.

On May 30, 2007, however, a Tax Court Memorandum case, Moore v. Commissioner,⁷ dealt squarely with the attempted exchange of a vacation home.

The Facts in Moore v. Commissioner

In 1988, the taxpayers, a married couple, purchased lakefront property in Lincoln County, Georgia (the "Clark Hill Property"). They used it for recreational purposes two to four weekends per month from April through Labor Day each year. Although they made substantial improvements to the Clark Hill Property and performed extensive maintenance on it, they never rented or even attempted to rent this property to others. On their Federal income tax returns, they deducted their mortgage interest as "home mortgage interest" and not "investment interest." Furthermore, they did not take any deductions for maintenance or other expenses.⁸

In 2000, the taxpayers sold the Clark Hill Property as part of an attempted tax-deferred exchange in which they acquired lakefront property in Forsyth County, Georgia (the "Lake Lanier Property"). Thereafter, they made comparable use of the Lake Lanier Property and treated it similarly for tax purposes until their divorce forced its sale.⁹

The Tax Court's Holding

In considering the exchange, the Tax Court noted, first, that the test for whether a taxpayer holds both the relinquished property and the replacement property for a proper purpose (i.e., for investment or in a trade or business) depends upon the taxpayer's primary purpose for holding each property, determined as of the time of the exchange.¹⁰ In Moore, the taxpayers contended that their primary purpose for holding each property was for appreciation. However, noting that, "…the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence," the Tax Court held that the taxpayers' primary purpose for holding each of these properties was for use as a secondary personal residence.

Clearly, the most important factor in the Tax Court's decision was the fact that the taxpayers had used each property exclusively for personal use. In this regard, the opinion cites the landmark Starker case for the proposition that "…exclusive use of property by the owner as his residence contradicts any claim by him that the property is held for investment."¹¹ In addition, the Tax Court noted that, at least as to the Clark Hill Property, the taxpayers deducted their mortgage interest as "home mortgage interest" rather than as "investment interest."¹²

The Tax Court also looked at what the taxpayers did not do:

• They never rented or even attempted to rent either property to others;
• They did not deduct expenses of maintenance and repair as to either property;
• They did not advertise the Clark Hill Property for sale until they had decided to purchase the Lake Lanier Property and they did not advertise the Lake Lanier Property for sale until their divorce.

Conclusion

Thus, Moore v. Commissioner stands for the proposition that if a taxpayer maintains a second home exclusively for personal use and does not rent it to third parties, the taxpayer will not be deemed to hold the property for investment and, therefore, tax-deferred exchange treatment will not be allowed.

However, this case does not hold that all second homes are ineligible for exchange treatment. To the contrary, the Tax Court indicates that the following factors will be considered in determining the taxpayer's primary purpose for holding the property:

1. Has the property actually been rented to others?
2. If so, how much has the property been rented relative to the taxpayer's personal use of the property?
3. If the property has not been rented, has a bona fide effort been made to rent it to others?
4. Has the taxpayer made a bona fide effort to sell the property other than as part of a tax-deferred exchange?
5. How has the taxpayer treated the property for federal income tax purposes? In particular:
   1. Has the taxpayer deducted mortgage interest as home mortgage interest or as investment interest; and
   2. has the taxpayer deducted expenses of maintenance and repair?

Given the Court's consideration of this wide range of factors, many vacation homes are likely to qualify for tax-deferred exchange treatment.

1. Richard A. Goodman is a partner in the Oakland, California, law firm of Goodman & Levine LLP. He is the author of Real Property Exchanges (California Continuing Education of the Bar 1982) as well as many articles on real estate and taxation, some of which are posted on his web page: www.the1031attorney.com. [Back]

2. IRC section 1031(a)(1).[Back]

3. Rev. Rul. 59-229. However, gain from the sale of property which a taxpayer has both owned and used as a principal residence for at least two years is excluded from income, up to a maximum of $250,000 ($500,000 for a married couple). IRC section 121. [Back]

4. The terms "second home" and "vacation home" are used interchangeably in this article. [Back]

5. IRC section 280A. [Back]

6. Since the requirement that property be held "for productive use in a trade or business" is more difficult to meet than the requirement that property be held "for investment," only the latter alternative will be considered in this article. [Back]

7. Moore v. Commission, T.C. Memo. 2007-134. A Tax Court Memorandum decision, such as this one, is reached by a single Tax Court judge. It is less authoritative, therefore, than one reached by a three judge panel. [Back]

8. The taxpayers here were ineligible to deduct any expenses of maintenance and repair under IRC section 280A since they did not rent either property to others. [Back]

9. The only significant difference was that the taxpayers deducted the interest on the Lanier Lake Property as investment interest, whereas they had deducted the mortgage interest on the Clark Hill Property as home mortgage interest. [Back]

10. Citing Bolker v. Commissioner, 81 T.C. 782, 804 (1983), aff'd. 760 F.2d 1039 (9th Cir. 1985) [Back]

11. Starker v. United States, 602 F. 2d 1341, 1350-1351 (9th Cir. 1979) [Back]

12. Deducting mortgage interest as "home mortgage interest" is more attractive, in general, to deducting it as "investment interest" as the latter is subject to certain limitations. [Back]