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Issue  47  Article  105
Published:  6/1/1999

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Vacation Property: Is it Investment Property?
John F. Murphy

(Note: This article is the second of three reprinted with the permission of the American Federation of Exchange Accommodators. All three will address various issues pertaining to IRS Section 1031 tax deferred exchanges)

I asked the following question last October at our Las Vegas meeting: Does vacation property qualify as investment property?

Section 1031 provides for the non-recognition of gain upon the exchange of "property held for productive use in a trade or business, or for investment, if such property is exchanged solely property of like kind which is to be held either for productive use in a trade or business or for investment."

While you can find examples of what qualifies as trade or business or investment property, you won’t find a definition of these terms. What then is a "vacation" property for purpose of 1031? Is it an investment property?

Three requirements must be satisfied in order to qualify for tax deferral under Section 1031: (1) the transaction must be an exchange; (2) the exchange must involve like-kind properties; and (3) both the properties transferred and the properties received must be held either for productive use in a trade or business or for investment. Sec. 1031(a)-1(a) and (c), Income Tax Regs. Brauer v. Commissioner, 74 T.C. 1134, 1139-1140 (1980).

The answer to the question of whether "vacation property" might qualify as "investments property" or "like-kind" will most likely be found in Reg. 1.1031(a)-1(b) under definitions of "like kind", which states "(u)nproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale."

While my fifth grade English teacher might have criticized the grammatical context of this sentence, it seems to state that property held for appreciation in value by one who is not a dealer is investment property.

The language of this regulation, originally proposed on May 29, 1956, was adopted on November 6, 1956 by T.D. 6210, and has remained unchanged since that time. Written by the Internal Revenue Service, it amounts to substantial authority for purposes of penalty assessment as provided for under Reg. 1.6661-3(b)(2). It would help if one could find a clear meaning of the term "unproductive real estate," but a search reveals no authoritative interpretation of its meaning.

The rules of statutory construction point us in the direction of reviewing other code sections, regulations, legislative comments, court opinions, administrative comments, etc., to help determine the meaning of the term; and if that search provides no help in determining the meaning of the term, then the plain meaning as might be found in Webster’s or Black’s Law dictionaries may very well be the source of the answer to this question. Statutes, 73 Am Jur 2d.

A search of the Tax Analysts CD tax code, regulations, revenue rulings, and private letter rulings uncovers no definition of the term "unproductive real estate." A search of the tax case law does not reveal its meaning either.

In Private Letter Ruling 8103117, the service did allow for Section 1031 treatment where that taxpayer intended to acquire property for personal enjoyment and as an investment. As stated in this P.L.R., "(t) he house and lot you acquire in this trade will be held for the same purposes as the properties exchanged therefore: to provide for personal enjoyment of the community and to take a sound real estate investment."

A plain reading would seem to support the argument that "personal enjoyment" of a property does not prevent it from being able to benefit from the provisions of Section 1031.

Often times individual taxpayers, as well as their advisors, are fearful of taking a position that is not clearly delineated in the tax rules. They do not want to fight the giant.

However, it should be remembered that taxing statutes conferring authority to impose taxes are to be strictly construed. "When statutes are so drawn that their…intent is in doubt… then it is the duty of the courts when litigation arises, to construe such statutes or ambiguities liberally in favor of the taxpayer or citizen against the tax authority." 71 Am Jur 2d Supp., 8 tax Statutes. The same rules apply to ambiguous regulations.

It should also be remembered that the legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether to avoid them, by means which the law permits us well recognized, 71 Am Jur 2d, 7. Evasion or avoidance of tax.

The fact that a property does not produce current income does not preclude the property from being treated as "investment property" as stated by the United States Tax Court in Ray v. Commissioner, Docket Tax Court No. 36379-85 (Nov. 27, 1989). Such a finding would merely preclude the current deduction of expenses under Section 212, Expenses for production of income. Further limits of current deductions can also be found under section 183, commonly referred to as the hobby loss provisions; Section 280A, Disallowance of certain expenses in connection with business use of the home, rental of vacation homes, etc,; and Section 469, Passive activity losses and credits limited, to cite a few loss limiting provisions.

While these cited sections limit the annual losses that might be taken in any one year, they do not prevent a property from being classified as "investment property."

While Section 1221 defines "capital assets," it does not explicitly define "investment property." Rather, it defines capital assets in terms of what is not a capital asset. Since a vacation property is not excluded, one could reasonably conclude that a vacation home must be a capital asset.

Perhaps Black’s Law Dictionary, 6th Edition, will provide an answer to the question of "unproductive real estate."

The nearest term that can be found was "produce" in the form of a verb, meaning "to yield, as revenue." From an accounting or tax sense I would think in terms of producing income, or in the negative, not producing income, as a reasonable meaning of the term "nonproductive real estate." Since a vacation property, used personally, would not produce income but could be an appreciating asset, it would seem to fit within the term as defined under the regulation.

For the less adventuresome, a private letter ruling request might be considered. Under Rev. Proc. 98-1, the user fees for such an application could range as little as $500 up to about $3,650, depending upon the gross income of the applicant. The application process would take about three to four months before an answer is given.

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