Don and Margaret owned a five-acre parcel consisting of their home, a work area used by Don in his construction business and a mobile home. They decided to sell this property so they could move to Missouri for semi-retirement. They planned to buy a campground there.

Their property was listed for sale at $650,000 with a local realty agent. Several months later, they were contacted by the owner of a nearby luxury house on a one-acre lot, listed for sale at $529,000. He proposed trading it for the five-acre parcel.

The parties agreed to exchange properties for $460,000 each. Don and Margaret received $150,000 cash, unsecured notes of $288,000 and $6,740 mortgage relief, and paid a $15,260 sales commission to their agent. They got a $300,000 mortgage on the luxury home and bought a Missouri campground for $132,500.

They immediately listed the luxury house for sale at $525,000. After it was on the market for five months, they sold it for $377,500, claiming a $133,592 capital loss on the sale. After offsetting their profit on the sale of their five acres, the couple claimed a $49,292 capital loss on the house sale.

However, the IRS denied this loss deduction. The IRS auditor argued that Don and Margaret did not have a profit motive in acquiring the luxury house in the trade. He said the real reason for the trade was that the house was more easily salable than the five-acre parcel. Don and Margaret took their dispute to U.S. Tax Court.

If you were the U.S. Tax Court judge, would you allow Don and Margaret to claim a $49,292 capital loss on the house sale?

The judge said no.

Because losses on the sale of a personal residence are not tax-deductible, the judge explained, Don and Margaret could deduct their loss on the luxury home sale only if they had a profit motive for acquiring it.

Four tests apply to determine if there is a profit motive, the judge said: (a) the manner in which the taxpayer carries on the activity, (b) the expertise of the taxpayer or his advisors, (c) the time and effort spent by the taxpayer on the activity and (d) the expectation that the assets will appreciate in market value.

There is no evidence Don and Margaret met any of these profit motive tests, the judge ruled. Acquisition of the luxury house was personal, rather than for business, he noted. Because it was more salable than their five-acre property, and because Don and Margaret never tried to rent it but held title for only a few months, their loss is not tax deductible, the judge concluded.

Based on the 1998 U.S. Tax Court decision in Taylor vs. Commissioner, T.C. Memo 1998-351.

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     Letters and comments to Robert J. Bruss, a San Francisco-area lawyer, author and real estate broker, may be sent to P.O. Box 280038, San Francisco, CA 94128. Bruss suggests consulting an attorney or tax advisor before making important real estate decisions.