                          T.C. Memo. 1997-37



                        UNITED STATES TAX COURT


                JAMES D. SCHLICHER, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 21305-94.               Filed January 21, 1997.




     Jon R. Vaught, for petitioner.

     Jeremy McPherson, for respondent.




               MEMORANDUM FINDINGS OF FACT AND OPINION

     PARR, Judge:    Respondent determined a deficiency in, and

additions to, petitioner's Federal income tax for the taxable

year 1988 as follows:

                                        Additions to Tax
        Year       Deficiency      Sec. 6651(a)(1) Sec. 6654
        1988       $98,917         $24,729.25       $6,326.15
                                 - 2 -


     After concessions by the parties,1 the only issue for

decision is:    Whether pursuant to section 1034(a), petitioner may

defer recognition of the gain from the sale of his principal

residence in Livermore, California, in excess of the amount

allowed by respondent.2    We hold he may as set out below.

                       FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulated facts and the accompanying exhibits are

incorporated into our findings by this reference.    At the time

the petition in this case was filed, petitioner resided in

Clayton, California.

     For 1988, petitioner did not file a Federal income tax

return, nor did he pay any Federal income tax for that year,

either through withholdings or estimated tax payments.    In 1988,

petitioner had taxable interest income of $13,416.    On December

31, 1988, petitioner was unmarried, and he did not have any

dependents.    To calculate the deficiency in issue, respondent

used the rate applicable to single persons.

1
     For 1988, the taxable year in issue, petitioner concedes
that he is liable for additions to tax under secs. 6651(a) and
6654(a), computed on any deficiency in tax for which we determine
he is liable.
     Both parties concede that each of the 51 acres of the
Clayton property purchased by the petitioner should be considered
to be of equal value.
2
     All section references are to the Internal Revenue Code in
effect for the year in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated. All dollar amounts are rounded to the nearest dollar,
unless otherwise indicated.
                              - 3 -

     In 1975, petitioner purchased a principal residence (the

Livermore residence) and approximately 5 acres of land in

Livermore, California (the Livermore property) for $52,000.   The

Livermore residence was approximately 1,000 square feet in size,

and there were several small farm structures on the property.

Between 1975 and 1988, petitioner made $25,000 in capital

improvements to the Livermore residence, and $25,000 in capital

improvements to the farm structures.   Petitioner's total adjusted

basis in the Livermore residence, farm structures, and 5 acres of

land was $102,000.

     While living on the Livermore property, petitioner operated

a mobile farrier (horse-shoer) business out his 1984 Dodge pickup

truck, which was equipped with a horse-shoeing camper.    Although

petitioner parked his truck on the property he did not operate

the farrier business on the Livermore premises.   In 1988,

petitioner received gross receipts from his farrier business of

$37,088,3 and paid deductible business expenses of $49,542.

     Petitioner also operated a horse boarding and breeding

business on pasture land that he leased from neighbors.   At any

given time, petitioner boarded approximately 30 horses for

clients on the leased premises.   In addition, petitioner kept one

stallion, approximately 6 brood mares, and 6 colts on the leased

premises, which he owned and used in his horse breeding business.

Petitioner did not use these horses for personal purposes.

3
     Petitioner's gross receipts from this activity are referred
to in the notice of deficiency as "Schedule C gross receipts."
                                - 4 -

Petitioner did not use any of the Livermore property for business

purposes.    In 1988, petitioner received gross receipts from his

horse boarding and breeding business of $28,188,4 and paid

deductible business expenses of $47,752.    Petitioner owned some

personal horses that he rode for pleasure, which he kept on the 5

acres used as his Livermore residence.    Petitioner had a fence

around the 5 acres, corrals that were used to exercise his

personal horses, and a barn used for boarding.    Petitioner did

not allow any of the boarded horses in the area where he kept his

personal horses.

     On July 18, 1988, petitioner sold the Livermore residence

and the 5 adjoining acres for $550,000.    He incurred $29,000 in

sale expenses.    Thus, the adjusted sales price was $521,000, and

petitioner's total adjusted basis was $102,000.    Therefore,

petitioner realized a gain from the sale of $419,000.

     In December of 1988, petitioner purchased 51 acres of

undeveloped land in Clayton, California (the Clayton Property),

for $380,000.    The property is comprised of an upper, steeply-

hilled wooded area and a plain.    The upper portion of the

property, which is zoned for residential building has a better

view of the surrounding countryside and of Mount Diablo than does

the plain.    The plain, where petitioner's boarding facility is

located, consists of a 100-year flood zone.    This area is also a

Native American archaeological site; therefore, petitioner is

4
     Petitioner's gross receipts from this activity are referred
to in the notice of deficiency as "Schedule F gross receipts."
                                - 5 -

legally precluded from constructing any residential buildings on

this portion of the property.   However, petitioner is permitted

to build agricultural structures on this portion of the land.

     Within the 2-year period following the date of sale of the

Livermore residence, petitioner incurred expenses of $146,922 to

construct a residence, garage, and a barn on the Clayton

property, which he used for personal purposes.   In this same time

period, petitioner spent substantial amounts of money to

construct buildings for use in his boarding and breeding

business.

     While living on the Clayton property, petitioner continued

to work as a farrier and to board and breed horses.    Petitioner

concedes that he operated his horse boarding and breeding

business on 7-½ acres of the Clayton property after the purchase.

At any given time, petitioner boarded an average of 30 horses on

the Clayton property, approximately the same number of horses

that he boarded on the leased premises in Livermore.   Petitioner

fenced off the horse boarding and breeding facility from the

remainder of the Clayton property using special fencing safe for

horses.   In the fenced area there is a 20-stall barn and paddocks

(an enclosed area used for pasturing or exercising horses).    Not

all of the boarded horses are kept in the stalls; some of them

stay in the fenced areas outside, while others remain in the

paddocks.
                                - 6 -

     Petitioner does not train horses on his premises, nor does

he give lessons or offer horseback riding facilities.    In fact,

access to the riding trails from the Clayton property is

obstructed by the presence of Mount Diablo.    If a boarding client

wants to train, ride, or exercise a horse the client must

transport the animal to another facility in the area.    The

business portion of the Clayton premises is not used for anything

other than breeding and boarding horses.

     While petitioner has several personal horses that are

generally located on the portion of the Clayton property not used

for business, occasionally he puts them with the boarded horses.

At no time, however, are the boarded horses permitted on the

residential portion of the Clayton property.

     When petitioner moved to Livermore it was substantially less

congested than it had become by the time petitioner sold the

property in 1988.    By 1988, petitioner could no longer keep many

horses on the property.    During this time, petitioner was also

having problems with his neighbors who were throwing cat litter

over his fence.    In addition, petitioner became increasingly

concerned about liability issues, because children in the

neighborhood would climb over his fence and get too close to his

personal horses.    Petitioner finally decided to sell the

Livermore property when one of these children got onto his

property and turned some of the horses loose.
                               - 7 -

     When petitioner decided to purchase the Clayton property, he

did not do so because it would be conducive to his business

operations.   Had this been petitioner's primary consideration, he

would have bought level land, rather than property consisting of

a steeply hilled area and a flood zone of archaeological

importance.   In fact, when looking for a new residence,

petitioner's first priority was to find a piece of property on

which he could live out "the rest of his life."   Petitioner

enjoys living in Clayton, because it is a secluded rural area

where he can be close to nature.   He also likes being in the

country where the houses are not close together, and where he

does not have to contend with less than congenial neighbors.

     Petitioner lived with his girlfriend, Patsy Lyons, at both

the Livermore and the Clayton residences.   Each of them rides

horseback and has ridden petitioner's personal horses on the

steeply-hilled portion of the Clayton property, and on the plain.

Petitioner uses the upper wooded area for hiking.   There is also

a dirt road that goes up the steeply hilled portion of the

property, which is accessible by car, horse, and foot. During the

springtime, petitioner's personal horses graze up there to keep

the grass down.   Petitioner never allows the horses from his

boarding or breeding business to use this area.   Petitioner keeps

all 51 acres of the Clayton property fenced off from neighboring

houses.
                               - 8 -

     When petitioner originally constructed his residence on the

Clayton property, he was considering building it in the upper

wooded area.   However, because that area needed extensive

clearing, petitioner would not have been able to prepare the site

and build a house within the 2-year period required by law.

Instead, petitioner built his residence above the plain on a

cleared plateau, which abutted the upper, steeply hilled section

of the Clayton property.

                              OPINION

Respondent determined a deficiency against petitioner for 1988 of

$98,917, and additions to tax under sections 6651(a) and 6654(a)

of $24,729 and $6,326, respectively.    These deficiencies were

based on respondent's determination that petitioner had capital

gains from the sale of his principal residence in Livermore,

California, because petitioner failed to establish how much of

the 51 acres of the new property, which he purchased in Clayton,

California, was used by him as his principal residence.5

Petitioner asserts that he used only 7-½ of the 51 acres of the

Clayton property for his horse boarding and breeding business,

that the remaining land was used as his principal residence, and

therefore that his investment therein qualifies for

nonrecognition treatment under section 1034(a).


5
      In the notice of deficiency, respondent failed to allocate
any portion of the 51 acres of the Clayton property to
petitioner's residence. However, at trial, respondent concedes
that 1 acre out of the 51 acres was used by petitioner as his
principal residence.
                                - 9 -

     Under the general rule of section 1001(c),6 petitioner is

required to recognize the gain on the sale of the Livermore

property.    However, pursuant to section 1034(a),7 a taxpayer may

defer gain from the sale of a principal residence provided such

gain is rolled over to a new principal residence within the time

prescribed in the statute.    Section 1034(a) provides that a

taxpayer must recognize gain from the sale of his principal

residence only to the extent the adjusted sales price8 of that

6
     Sec. 1001(c) provides in pertinent part as follows:

          (c) Recognition of Gain or Loss.--Except as
     otherwise provided in this subtitle, the entire amount
     of the gain or loss, determined under this section, on
     the sale or exchange of property shall be recognized.
7
     Sec. 1034(a) provides in pertinent part as follows:

          (a) Nonrecognition of Gain.--If property (in this
     section called "old residence") used by the taxpayer as
     his principal residence is sold by him and, within a
     period beginning 2 years before the date of such sale
     and ending 2 years after such date, property (in this
     section called "new residence")is purchased and used by
     the taxpayer as his principal residence, gain (if any)
     from such sale shall be recognized only to the extent
     that the taxpayer's adjusted sales price (as defined in
     subsection (b)) of the old residence exceeds the
     taxpayer's cost of purchasing the new residence.
8
     Sec. 1034 (b) provides in pertinent part as follows:

            (b) Adjusted Sales Price Defined --

                 (1) In general--For purposes of this section, the
            term "adjusted sales price" means the amount realized,
            reduced by the aggregate of the expenses for work
            performed on the old residence in order to assist in
            its sale.

                 (2) Limitations--The reduction provided in
            paragraph (1) applies only to expenses--
                                                     (continued...)
                                - 10 -

residence exceeds the cost of property purchased and used as a

new principal residence within 2 years before or after the date

of sale.   Moreover, where part of the new residence purchased is

used as the taxpayer's principal residence and part is used for

business purposes, only the portion of the cost allocable to the

residential use is entitled to section 1034(a) nonrecognition.

Beckwith v. Commissioner, T.C. Memo. 1964-254; Grace v.

Commissioner, T.C. Memo. 1961-252; sec. 1.1034-1(c)(3)(ii),

Income Tax Regs.    Thus, pursuant to section 1034(a) and the

regulations thereunder, only the portion of the Clayton property

used by petitioner as his principal residence during the 2-year

period following the sale of the Livermore property may be

included in the cost of purchasing such residence.    Whether or

not property is used by a taxpayer as his residence depends upon

all the facts and circumstances in each case, including the good

faith of the taxpayer.     Thomas v. Commissioner, 92 T.C. 206, 243

(1989); sec. 1.1034-1(c)(3)(i), Income Tax Regs.


8
 (...continued)
                       (A) for work performed during the 90-day
                  period ending on the day on which the contract to
                  sell the old residence is entered into;
                       (B) which are paid on or before the 30th day
                  after the date of the sale of the old residence;
                  and
                       (C) which are--
                            (i) not allowable as deductions in
                       computing taxable income under section 63
                       (defining taxable income), and
                            (ii) not taken into account in computing
                       the amount realized from the sale of the old
                       residence.
                             - 11 -

     To carry his burden of proof, thus entitling petitioner to

the nonrecognition benefits of section 1034, he must prove that

he has satisfied all of the section's requirements.   Rule 142;9

Welch v. Helvering, 290 U.S. 111, 115 (1933); Durando v. United

States, 70 F.3d 548, 550 (9th Cir. 1995).




9
     At trial and on brief, petitioner asserts that respondent's
notice of deficiency was arbitrary and excessive and not entitled
to a presumption of correctness, thus shifting the burden of
proof to respondent where, in determining the deficiencies for
the taxable year in issue, respondent failed to allow for the
cost of any of the replacement real property in Clayton,
California. To support his position, petitioner relies on such
cases as Herbert v. Commissioner, 377 F.2d 65, 69 (9th Cir.
1966), revg. T.C. Memo. 1964-223; Jackson v. Commissioner, 73
T.C. 394, 401 (1979); and Dellacroce v. Commissioner, 83 T.C. 269
(1984). However, petitioner's reliance on this line of cases is
misplaced.
     It is well settled that the Commissioner's determinations in
a notice of deficiency generally are presumed correct, and the
taxpayer bears the burden of proving that those determinations
are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111,
115 (1933); Durando v. United States, 70 F.3d 548, 550 (9th Cir.
1995). However, a showing that the statutory notice is arbitrary
and excessive within the rule of Helvering v. Taylor, 293 U.S.
507 (1935), may have the effect of shifting the burden of going
forward to respondent. Jackson v. Commissioner, supra.
      As a general rule, this Court will not look behind the
statutory notice of deficiency to examine the evidence used in
making the determination. Jackson v. Commissioner, supra at 400.
On rare occasions, however, we have recognized an exception to
the foregoing rule in cases involving unreported income, where
the respondent introduced no predicate evidence but rested on the
presumption of correctness and the petitioner challenged the
notice of deficiency. Dellacroce v. Commissioner, supra at 280
citing Jackson v. Commissioner, supra; Delaney v. Commissioner,
T.C. Memo. 1982-666, affd. 743 F.2d 670 (9th Cir. 1984).
     Petitioner contends that his case is governed by the
exception rather than the general rule. We disagree.
Respondent's determination is not based on petitioner's alleged
unreported income. Therefore, petitioner does not fall within
the exception described above. Accordingly, the burden of proof
rests with the petitioner. Rule 142(a).
                               - 12 -

     Petitioner sold the Livermore residence and adjoining 5

acres for an adjusted sales price of $521,000, and realized a

gain from the sale of $419,000.    Under the provisions of section

1034(a), petitioner must recognize such gain to the extent that

the portion of the cost of the Clayton residence, which is

allocable to residential use, is less than $521,000.    Petitioner

purchased 51 acres of undeveloped land in Clayton, California for

$380,000.   He also spent $146,922 to construct a residence,

garage, and barn.    There is no dispute that the Livermore

residence and adjoining 5 acres are to be treated as residential

in their entirety.    Moreover, the parties agree that the gain

realized from the sale of the Livermore property, to the extent

attributable to the portion of the Clayton property used for

petitioner's horse boarding and breeding business, does not

qualify for section 1034(a) nonrecognition.    However, where the

parties diverge is with respect to the number of acres of the

Clayton property that petitioner used as his residence.    In

making an allocation between residential and business use, we

note that neither the statute, nor the applicable regulation, nor

case law provides a specific method for determining what portion

of a realized gain is attributable to the nonresidential use of

the new residence.    Section 1.1034-1(c)(3)(ii), Income Tax Regs.,

merely states that "an allocation must be made."    Wigfall v.

Commissioner, T.C. Memo. 1982-171.
                               - 13 -

     In support of her position that petitioner used only 1 acre

of the Clayton property as his residence, respondent heavily

relies on Beckwith v. Commissioner, T.C. Memo. 1964-254.      We do

not agree that Beckwith is controlling in light of the facts of

the instant case.

     In Beckwith, the taxpayer purchased approximately 80 acres

of land, built a residence on the property, and asserted that the

portion of the land not used for business must necessarily be

regarded as his residence.   Respondent contends that the facts in

Beckwith, are closely analogous to the facts at issue here.     We

disagree.   In Beckwith, nearly 40 of the 80 acres purchased by

the taxpayer were held in reserve under a soil conservation

contract with the U.S. Department of Agriculture and

approximately 28 acres consisted of marshland and some wooded

area.   With respect to the land held in reserve by the United

States, we found that the taxpayer's residence could not

reasonably be said to include these acres.

        In the case at bar, however, there is no restriction on

petitioner's right to use all 51 acres of his land, except to the

extent that he is precluded from building residential structures

on the flood plain because of its archeological importance.

Petitioner may build, and has indeed built, agricultural

structures on such property.   Moreover, petitioner uses a portion

of this area for his boarding and breeding business.   With

respect to the wooded area in Beckwith, we held that this was not
                              - 14 -

part of the residence, noting that the taxpayer had used some of

this area to conduct helicopter experiments, which detracted from

its characterization as a residence.    More importantly, the

taxpayer in Beckwith only regarded the house itself and 5

appurtenant acres as his residence.    However, in the instant

case, the petitioner regards and uses all of the Clayton property

as his residence, except for the portion allocated to his

business.   At trial, the petitioner repeatedly and unequivocally

testified that he moved to the Clayton premises, because he

appreciates nature, admires unobstructed views of the

countryside, enjoys living in open spaces where he can hike and

ride horseback, and ultimately desires to live the rest of his

life there.   We find petitioner's testimony to be credible.

     On brief, the respondent relies on Grace v. Commissioner,

T.C. Memo. 1961-252, for the proposition that occasional or

insignificant use of property, such as for storage of business

tools, is not sufficient to determine its character as business

property.   In Grace, we found a taxpayer's business use of his

residence to be "insignificant," where he merely stored

construction tools in part of his basement.    Accordingly, we held

that an allocation between the business and residential use was

not required for purposes of section 1034(a) nonrecognition.

Respondent, treating the instant case as the converse of Grace,

contends that the petitioner here used the upper, steeply hilled

section of the Clayton property only "insignificantly," and thus
                                - 15 -

such use was insufficient to constitute residential use as

required by section 1034(a).

     We find that respondent's reliance on Grace is misplaced.

In Grace we concluded that a taxpayer's storing business tools in

the basement of his home was insignificant business use, so that

no allocation was required for purposes of section 1034 and the

regulation thereunder.   However, it does not follow that

petitioner's use of the upper, steeply hilled portion of his

property was so insignificant as to establish that it was not

used by him as his residence.    Moreover, we do not believe that

petitioner's use of this area was insignificant.

      Petitioner and his girlfriend, Patsy Lyons, have used the

upper, steeply hilled portion of the Clayton property for

horseback riding, hiking, walking, and simply to enjoy the

unobstructed view of the countryside and Mount Diablo.   During

the springtime petitioner's personal horses graze up there.

When petitioner originally built his principal residence on the

Clayton property, he was considering building it in the upper

wooded area.   However, he chose not to do so, because he would

not have been able to clear the area and build a house within the

2-year period of section 1034.

     Based on the entire record, we find that petitioner's use of

the upper, steeply hilled area was significant, and sufficient to

constitute residential use.    Cf. Grace v. Commissioner, supra.

     Petitioner asserts that he used only 7-½ acres of the
                               - 16 -

Clayton property for business and that the remaining 43-½ acres

were used as his residence.   To support his position, petitioner

relies on cases, such as Richards v. Commissioner, T.C. Memo.

1993-422 (respondent agreed that the taxpayer's homesite and 28.6

acres of dry pasture land constituted residential property);

Estate of Campbell v. Commissioner, T.C. Memo. 1964-83 (where the

taxpayer's residence is part of a property also used for

business, nonrecognition applies not only to the home itself, but

to the environs and outbuildings relating to the dwelling unit);

and Bennett v. United States, 61-2 USTC par. 9697, 8 AFTR2d 5593

(N.D. Ga. 1961) (the taxpayer's residence included an entire 65-

acre tract, rather than the 2-½ acres determined by respondent).

We agree with petitioner.

     At trial, petitioner testified that at any given time, he

boarded an average of 30 horses on the Clayton premises, which

was approximately the same number of horses that he boarded in

Livermore.   Petitioner kept these horses fenced off from the

remainder of the Clayton property using special fencing safe for

horses. In the fenced area there is a 20-stall barn and paddocks.

Petitioner keeps some of the boarded horses in the stalls, some

in the fenced areas outside, while others remain in the paddocks.

At trial, petitioner testified, and we find as fact that the

boarded horses were never allowed on the upper section of the

property.    The testimony of Mr. Vogel, the revenue agent called

as a witness for respondent, supports petitioner's testimony.     At
                                - 17 -

trial, Mr. Vogel, who had been to the Clayton property more than

a half of a dozen times, testified that he never saw any horses

on the upper, steeply hilled portion of the Clayton property.

     Petitioner testified that he does not train horses on his

premises, nor does he give riding lessons or offer horseback

riding facilities.    Access to the riding trails from the Clayton

property is obstructed by the presence of Mount Diablo; therefore

a boarding client who wants to train, ride, or exercise his or

her horse must transport the animal to another facility in the

area.   Furthermore, because petitioner uses the business portion

of the Clayton premises solely for breeding and boarding horses

he needs less land for such business, than, for example, someone

who operates a horse training and horseback riding facility.

     Finally, we mention in passing that the good faith of a

taxpayer is taken into account in determining whether or not

property is used by a taxpayer as his residence.     Thomas v.

Commissioner, 92 T.C. 206, 243 (1989); sec. 1.1034-1(c)(3)(i),

Income Tax Regs.     In assessing petitioner's credibility we note

that we were influenced by the testimony of     Mr. Vogel, the

revenue agent who was called as witness for respondent.     At trial

Mr. Vogel testified that petitioner's girlfriend and bookkeeper,

Patsy Lyons, spent a substantial amount of time with him

reconstructing petitioner's records.     Moreover, the agent

testified that both she and the petitioner were very cooperative

and that he had "complete faith that what she was telling * * *
                               - 18 -

[him] was correct."    Given that the petitioner is a credible

witness and based on the entire record we find that petitioner

used only 7-½ of the 51 acres of the Clayton property for

business.

     On brief, respondent argued in the alternative that the

remaining 43-½ acres of the Clayton property not used for

business were held by petitioner for investment.    Respondent

contends that the upper, steeply hilled portion of the Clayton

property, which is zoned for residential use, could be divided

into home sites that petitioner could then sell for a profit.

Respondent points to the fact that petitioner had a 280-foot well

drilled on one of the home sites for future use as evidence that

petitioner held this portion of the Clayton property for

investment.    We disagree.

     Before building his current residence, petitioner drilled a

well on the upper, steeply hilled portion of the land to make

sure that he "could hit water."    However, petitioner decided it

was more practical to build elsewhere on the site.    Whatever

desire petitioner had to build on the upper portion was abandoned

when he built his current residence, and remains no more than a

vague dream.    Moreover, petitioner enjoys solitude and credibly

testified that he did not purchase the Clayton property for

investment purposes, but rather as a place where he could live

"the rest of his life," untroubled by close neighbors.
                              - 19 -

     Accordingly, we find that petitioner held the remaining 43-½

acres as his residence and not for investment. Residential

purposes may include appreciating nature, living in open spaces,

hiking, horseback riding, and enjoying unobstructed views of the

countryside.   In fact, this is quite common in the Western

portion of our country, as in Clayton, California, where land is

more plentiful.   Nothing in section 1034 prohibits us from

finding that such use constitutes "significant use" for

residential purposes.   Accordingly, we find that petitioner has

met his burden of proving that he used the remaining 43-½ acres

of the Clayton property as his residence.

     To reflect the foregoing,



                                       Decision will be entered

                                  under Rule 155.
