Hard to believe we've turned the clock to 2008! And as we begin a new year, it's a perfect time to plan for what's ahead. For those of you planning on filing for tax deferral treatment under IRS Code Section 1031, here are a few reminders:

• The tax deferred exchange must be complete prior to either 180 days from the first sale or the tax filing date (including extensions). Therefore, if taxpayers began their exchange period after October 18, 2007, it is wise to discuss potential tax filing extensions with a tax advisor.
• The form required for this treatment is IRS Form 8824.
• Tax advisors will benefit by the supporting documentation including:
• Contractual Exchange Agreement
• Fully Executive Offer to Purchase Agreement
• Assignment of Relinquished and Replacement Property Forms
• HUD-1
• Statewide Title Exchange Corporation provides each of its clients with a full set of pertinent documents upon the conclusion of the exchange.

If you are planning to enter into a 1031 Tax Deferred Exchange in 2008, seek the counsel of a competent tax advisor or tax attorney. There are several issues that need to be addressed prior to entering into an exchange - the first of which will be the financial impact to the taxpayer. Other issues can include the structure of an exchange required, appropriate property vesting, and holding periods. Inappropriate or inaccurate application of the rules pertaining to any of these issues (or others) can lead to a failed exchange, and often costly repercussions. Investing in counsel prior to these decisions can mean tremendous savings for the taxpayer.

Between its mountainous western counties, its piedmont lakes and its 130 miles of coastline, North Carolina has a tremendous number of vacation homes and resort rental properties. As one might expect, any Exchange Company headquartered in such a location must deal frequently with questions concerning the qualification of such properties for treatment under Section 1031 of the Internal Revenue Code (sec. 1031, I.R.C.). Historically, there has not been much specific guidance from the IRS concerning treatment of such properties under Section 1031, therefore one must infer what their position might be from several different sections of the Code together with revenue rulings and private letter rulings applicable to those sections. Not surprisingly, this has resulted in disparate opinions being voiced in the counseling of taxpayers by various exchange industry advisors.

In the U. S. Tax Court decision in Moore v. IRC, T.C. Memo., 2007-134, released on May 30, 2007 the IRS's position as accepted by the Tax court is now much clearer. The decision will come as no surprise to those who applied existing doctrine conservatively. The more adventuresome souls are surely anticipating the expiration of relevant statutes of limitations with some measure of anxiety. The case involved two separate tax issues and we will ignore the portions of the Tax Court's discussion that is not related to Exchanges.

The plaintiffs purchased a vacation home in their home state of Georgia in 1988 on two lots on Clark Hill Lake. The family used the home for recreational purposes during the spring and summer months. The plaintiffs relocated in the mid 90's which lengthened the commute to the vacation home and in 1999 they decided to purchase another vacation home closer to their new home. In 2000, the plaintiffs disposed of the first vacation home and acquired a replacement vacation home pursuant to a series of transactions that were intended to qualify as a tax deferred, like-kind exchange under sec. 1031, I.R.C. The plaintiffs and their children used both vacation homes exclusively for recreational purposes, and the plaintiffs never rented or offered to rent either vacation home to third parties. One of the stated motives of the plaintiffs' for acquiring and holding each vacation home was the prospect of an appreciation in value that might result in a profit on the eventual sale of the properties.

The plaintiffs' decision to purchase the Georgia vacation property was motivated, in part, by the fact that both their families owned property on or near it, and they had been advised that property on Clark Hill Lake had appreciated and would continue to appreciate. Their decision to invest in real estate rather than in intangibles, such as stocks or bonds, was influenced by a prior bad experience with a financial adviser who had stolen their money. When they purchased the Clark Hill property in 1988, their primary residence was in Norcross, Georgia, a 3-hour drive. In 1995 or 1996, petitioners changed their primary residence to Marietta, Georgia between a 5 and 6 hour drive.

The plaintiffs used the property with their family a few weekends each month during seasonal weather and for maintenance during the winter. They made improvements to the property and to the mobile home located there over the years that enhanced its value. They refused to sell the property even though they had been offered money for it up until the time that they decided to acquire the Lake Lanier property. They never rented, attempted to rent the home to others or had ever advertised the Clark Hill property for sale until then. They listed deductions for "home mortgage interest" on their Federal income tax returns, but they did not list any deduction for investment interest, maintenance or other expenses associated with the Clark Hill property on those returns.

After they moved from Norcross to Marietta, Georgia, the inconvenience of the longer drive to the Clark Hill property was compounded by their children's increased local weekend activities. As a result, they used the property less and less frequently. It then became a chore just to maintain the property, so that it became rundown and had to be either renovated or sold. This caused the plaintiffs to investigate properties on Lake Lanier, which is much closer to their Marietta, Georgia home. They felt that a house on Lake Lanier would be of more use to them and that property on Lake Lanier would appreciate more rapidly than the Clark Hill property because it was closer to the metropolitan Atlanta area.

The Lake Lanier property consisted of a 1.2-acre plus tract of land, with the "largest double slip dock allowable on the lake (complete with two lifts), and a house that had five screened-in porches overlooking the lake, a full party deck, a covered veranda, a great room with a stone fireplace, five bedrooms, and 4-1/2 bathrooms. At the time of purchase, the house was partially furnished, and, after purchase, petitioners completed the furnishing themselves. They installed a satellite TV system and a VHS recorder, and, before their second summer at the property, they purchased a motorboat with room for six to eight passengers."

The occupied the property in essentially the same fashion as they had at the Clark Hill property prior to their move. They claimed deductions for home mortgage and investment interest paid on their loan to purchase the property on their tax return. They did not list on their 2000-02 returns any deductions for maintenance or other expenses associated with the Lake Lanier property as they had not for the Clark Hill property. Nor did they ever rent or attempted to rent the Lake Lanier property. They never offered it for sale until forced to do so in connection with the division of their assets incident to their divorce.

There were other issues before the Court, but in this case, in order to prevail on the section 1031 issue, they needed to satisfy the Court that they held both properties for investment. This depends on their intent determined as of the time of the exchange.

The court's analysis of this issue follows, unedited as it is very illustrative.

"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. Montgomery v. Commissioner, T.C. Memo. 1997-279 ("section 1031 requires that both the property transferred and the property received in a like-kind exchange be held primarily for productive use in a trade or business, or for investment."), affd. in part and revd. in part on another issue without published opinion 300 F.3d 866 (10th Cir. 1999). Indeed, in Starker v. United States, 602 F.2d 1341, 1350-1351 (9th Cir. 1979), the U.S. Court of Appeals for the Ninth Circuit recognized the longstanding rule that the exclusive use of property by the owner as his residence contradicts any claim by him that the property is held for investment. The court applied the rule specifically to section 1031 exchanges. The court said:

"A similar rule must obtain in construing the term 'held for investment' in section 1031. … [Id.; citations omitted.] This and other courts have reached the same conclusion in the context of deciding whether expenses incurred with respect to a personal residence are deductible under section 212(2) as 'expenses paid or incurred … for the management, conservation, or maintenance of property held for the production of income'. Property held for investment is property held for the production of income within the meaning of section 212. See Newcombe v. Commissioner, 54 T.C. 1298, 1302 (1970) (an expense deduction is justified under section 212(2) only if the property to which it relates 'is "held for investment," i.e., for the production of income'); sec. 1.212-1(b), Income Tax Regs. Thus, both section 1031 and section 212(2) involve the same factual inquiry whether the property in question was held for investment."

"As a preliminary matter, we accept as a fact that petitioners hoped that both the Clark Hill and Lake Lanier properties would appreciate. However, 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. See Jasionowski v. Commissioner, 66 T.C. 312, 323 (1976) ('if the anticipation of eventually selling the house at a profit were in itself sufficient to establish that the property was held with a profit-making intent, rare indeed would be the homeowner who purchased a home several years ago who could not make the same claim'). Moreover, a taxpayer cannot escape the residential status of property merely by moving out. In Newcombe v. Commissioner, supra, the taxpayers listed their former residence for sale on or about the day they moved out, December 1, 1965. They sold the property at a loss on February 1, 1967. The issue in Newcombe relevant to this case was whether, during 1966, the property was held for the production of income (i.e., for investment) so as to entitle the taxpayers to deductions for maintenance expenses under section 212(2). In denying those deductions we stated: The taxpayer must … be seeking to realize a profit representing post-conversion appreciation in the market value of the property. Clearly, where the profit represents only the appreciation which took place during the period of occupancy as a personal residence, it cannot be said that the property was 'held for the production of income.' … [Id. At 1302.]

We added: 'The placing of the property on the market for immediate sale, at or shortly after … its abandonment as a residence, will ordinarily be strong evidence that a taxpayer is not holding the property for post-conversion appreciation in value.' Id."

"This Court has frequently applied the reasoning of one or both of Jasionowski and Newcombe in rejecting taxpayer arguments that because a second or vacation home was held for appreciation (i.e., investment) the taxpayer was entitled to a deduction, under section 212(2), for expenses incurred to maintain or improve the property. See, e.g., Ray v. Commissioner, T.C. Memo. 1989-628; Houle v. Commissioner, T.C. Memo. 1985-389; Gettler v. Commissioner, T.C. Memo. 1975-87. In both Ray and Houle we denied the deductions on the ground that the taxpayers treated the houses as a "second home" (Ray) or 'second residence' (Houle). In Gettler, we denied the deductions, concluding that "the primary purpose in both acquiring the house and holding on to it was to use it as a vacation home." The cited cases stand for the proposition that the holding of a primary or secondary (e.g., vacation) residence motivated in part by an expectation that the property will appreciate in value is insufficient to justify the classification of that property as property 'held for investment' under section 212(2) and, by analogy, section 1031."

The court in conclusion stated that "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." The case law that the plaintiffs argued supported their position actually involved taxpayers that never occupied the properties, nor used them for personal purposes "and, although the taxpayers' children and friends stayed in both properties, they paid fair market rent to the taxpayers."

The Court's conclusion was that neither the Clark Hill nor Lake Lanier property was property held for investment for purposes of Section 1031 and that the plaintiffs' transfers did not qualify as a tax deferred "like-kind" exchange of properties under Section 1031. As we initially noted, this conclusion should be considered unsurprising. Advisors who have been relying on the absence of express guidance will need to re-think the issue. In many quarters it will even be considered welcome as it will make it significantly easier to deal with taxpayers who are resistant to compliance.

It is important to note that the plaintiffs' personal use of the property disqualified it for the purpose of deducting depreciation on it or expenses for its maintenance other than interest and taxes on their tax return. While the court noted that they didn't make these deductions, it is clear that they couldn't. For those looking for a simple rule in this regard, one might consider generalizing the issue for improved resort/vacation property as, if you can't depreciate it or deduct expenses due to personal use limitations, you probably can't qualify for 1031 treatment as relinquished or replacement property.

You can learn more about these and several other topics in the 1031 Seminar Series produced and presented by Statewide Educational Services. We are authorized sponsors providing continuing education credit to attorneys, real estate professionals and CPAs throughout North Carolina. Our next session will be held on Friday 2/1/2008 in Kitty Hawk, North Carolina. Details on this seminar can be found on our website: Statewide Seminars. The full 2008 schedule will be posted shortly.