August, 2007 Tax Newsletter

Is Your Vacation Home an Investment for Tax Purposes?

Several of my clients own second homes or vacation homes which they use during the year.  In most cases the value of the home has increased to the point where, if sold, the home would result in a significant capital gain tax.  This is very much in line with one’s motivation in acquiring a vacation home in the first place – to have it available for personal enjoyment while hopefully watching it appreciate over time.

The issue recently addressed by the Tax Court is whether the exchange of an appreciated vacation home for another vacation home would qualify as a tax-free exchange under sec. 1031 of the tax code

In order to qualify under sec. 1031, both the property exchanged and the property acquired must be held for productive use in a trade or business or for investment.  The court held that the exchange did not qualify because the residence was not strictly held for investment purposes.  It found that the primary purpose in acquiring and holding both homes was to enjoy the use of the properties as vacation homes.  In the words of the court, “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”.

It should be noted that the taxpayers in this case did not take any deductions for investment expenses or otherwise treat either property as investment properties for tax purposes.  This very likely influenced the court’s decision in finding that their investment intent was secondary to their vacation home intent.