                  T.C. Memo. 1999-347



                UNITED STATES TAX COURT



   LEE F. PARKER AND DIANE K. PARKER, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 9590-98.             Filed October 20, 1999.




     For purposes of deferring gain on the sale of their
former residence under sec. 1034, I.R.C., Ps sought to
include expenditures made in the construction of an
unfinished dwelling structure. The structure was located on
the same lot as the new residence purchased by Ps, and Ps
intended eventually to use both buildings for their
residential purposes. At the close of the 2-year statutory
period for reinvestment and deferment of gain, Ps had not
yet moved into the new structure and were instead using it
largely as a workshop area. On the facts, Held: Ps have not
placed the structure into residential use as required by
sec. 1034, I.R.C., and are thus not entitled to include its
costs in order to defer recognition of gain on the sale of
their former residence. R’s determination of a deficiency
is sustained.
                                 - 2 -

        Curtis W. Berner, for petitioners.

     Usha Ravi, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION

        NIMS, Judge: Respondent determined a Federal income tax

deficiency for petitioners’ 1991 taxable year in the amount of

$54,341.     The sole issue for decision is whether, for purposes of

section 1034, petitioners may include expenses incurred in

constructing a structure intended for eventual residential use as

part of the cost of their new principal residence, thereby

enabling them to defer recognition of gain on the sale of their

former residence.

     Unless otherwise indicated, all section references are to

sections of 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.

                           FINDINGS OF FACT

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

Mr. and Mrs. Parker (petitioners) sold their residence in Los

Angeles, California, on December 24, 1991, for an adjusted sales

price of $363,353.    They realized a gain of $182,239 on the sale,

but they deferred recognition of this gain pursuant to section

1034.     Then, on May 19, 1992, they purchased a home in Turlock,

California, for $169,500.     Petitioners moved into the 1,400-
                               - 3 -

square-foot home on the Turlock property the following month and

continued to occupy that dwelling as their residence up to and

through the time of trial.

     Shortly after moving in, because the existing 1,400 square

feet were insufficient to accommodate the needs of their family,

petitioners began preparations for building additional living

space.   Initially, petitioners contemplated constructing an

attached addition.   A power line easement, however, rendered such

a plan unworkable.   Hence, petitioners decided to build a

detached residential structure of more than 3,000 square feet on

the Turlock property, to be located behind the existing home.

Mr. Parker (petitioner) had read about the tax benefits available

under section 1034, and he inquired of his tax accountant whether

the cost of the detached unit would qualify as part of the

purchase price of the new residence.   The tax accountant

indicated that it would.

     Prior to beginning construction, petitioners applied for and

obtained a building permit from the City of Turlock for what the

permit designated a “new” “SFD” (single family dwelling).

Petitioners likewise secured a conditional use permit and

variance to have the existing 1,400-square-foot home redesignated

and allowed to remain in place as a “second dwelling unit on a

single family zoned lot”, in accordance with Turlock Municipal

Code section 9-2-506.   These administrative steps were
                                - 4 -

necessitated by petitioners’ plans for the new structure to

include, on two floors, a living room, kitchen, great room,

bedrooms, bathrooms, laundry room, art studio, and garage, such

that two fully functional dwelling structures would be located on

the single lot.

     After the building permit was approved in March of 1993,

petitioner was able to begin construction.    In order to reduce

cost, he did most of the work himself, when his employment in and

income from the film production industry would allow.

     From April 21, 1992, to December 22, 1993, petitioners made

capital expenditures of $210,545.96 relating to the Turlock

property, in connection with either the existing residence or the

new structure.    When these costs are combined with the purchase

price, the amount spent totals $380,045.96.    Nonetheless, as of

December 24, 1993, petitioners had never slept in the new

structure.   There was no central heating to the house at that

time.   The rough electrical, plumbing, and heating/ventilation

systems were not approved until September of 1997.    The kitchen

and garage were being used as a workshop at the end of 1993.

Only one bath had a sink and toilet installed.    As of early 1999,

construction work continued in the living room, kitchen, great

room, bedrooms, bathrooms, laundry room, and art studio of the

new structure.    Petitioners’ furniture and household goods
                                 - 5 -

remained in the original home.    At the time of trial, petitioner

had been working on the project for more than 6 years, and the

date of completion remained uncertain.

                              OPINION

     We must decide whether petitioners’ expenditures in

constructing a separate structure for future residential use are

properly included as part of the cost of their new principal

residence for purposes of section 1034.   If so, petitioners are

entitled to defer recognition of gain on the sale of their former

residence.   If not, petitioners are liable for the deficiency

determined by respondent.

     Petitioners contend that the separate structure should be

viewed as an addition, albeit detached, to their existing

residence.   Further, petitioners assert that a mere addition or

capital improvement to an established new residence need not be

placed into actual residential use in order for costs incurred in

its construction to be added to the total purchase price for

purposes of section 1034.

     Conversely, respondent contends that failure by petitioners

to use the separate structure as a principal residence within the

statutory time period defeats their attempt to have costs
                                - 6 -

incurred in its construction included as part of their purchase

price for the section 1034 calculation.     We agree with respondent

that residential use is an essential prerequisite to cost

inclusion.

                        Statutory Provisions

     Under sections 1001 and 61, taxpayers generally must

recognize in the year of sale all gain or loss realized upon the

sale or exchange of property.   Section 1034, however, provides an

exception which allows taxpayers to defer recognition of gain

when sale proceeds are reinvested in a new principal residence.

The section reads, in pertinent part, as follows:

     SEC. 1034. ROLLOVER OF GAIN ON SALE OF PRINCIPAL
       RESIDENCE.

          (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 * * *
     of the old residence exceeds the taxpayer’s cost of
     purchasing the new residence.

               *    *     *     *       *   *   *

          (c) Rules for Application of Section.-–For
     purposes of this section:

               *    *     *     *       *   *   *

               (2) A residence any part of which was
          constructed or reconstructed by the taxpayer shall
          be treated as purchased by the taxpayer. In
          determining the taxpayer’s cost of purchasing a
                                 - 7 -

            residence, there shall be included only so much of
            his cost as is attributable to the acquisition,
            construction, reconstruction, and improvements
            made which are properly chargeable to capital
            account, during the period specified in
            subsection(a).

(Section 1034 was repealed by section 312(b) of the Taxpayer

Relief Act of 1997, Pub. L. 105-34, 111 Stat. 839, generally

effective for sales and exchanges of principal residences after

May 6, 1997.    The section 1034 rollover provision was replaced by

an expanded and revised section 121.)

                        General Interpretation

     As a threshold matter, section 1034 specifies that gain must

be reinvested in property “purchased and used by the taxpayer as

his principal residence” in order for nonrecognition treatment to

be available.    In ascertaining what is meant by “used” as a

“principal residence”, this Court has stated in an oft-quoted

pronouncement: “The elements of residence are the fact of abode

and the intention of remaining, and the concept of residence is

made up of a combination of acts and intention.    Neither bodily

presence alone nor intention alone will suffice to create a

residence.”     Stolk v. Commissioner, 40 T.C. 345, 353 (1963),

affd. 326 F.2d 760 (2d Cir. 1964); see also Perry v.

Commissioner, 91 F.3d 82, 85 (9th Cir. 1996), affg. T.C. Memo.

1994-247.

     With respect to the abode element, courts have consistently

focused upon actual, physical use and occupancy as a prerequisite
                                - 8 -

to the benefit of deferring gain recognition.   Explicit and

unambiguous judicial language such as the following has left

little room for question: “for property to be ‘used by the

taxpayer as his principal residence’ within the meaning of

section 1034(a), that taxpayer must physically occupy and live in

the house.”   Perry v. Commissioner, supra at 85 (quoting Young v.

Commissioner, T.C. Memo. 1985-127).

     Concerning the intent element, section 1.1034-1(c)(3)(i),

Income Tax Regs., interpreting section 1034 provides:

     Whether or not property is used by the taxpayer as his
     residence, and whether or not property is used by the
     taxpayer as his principal residence (in the case of a
     taxpayer using more than one property as a residence),
     depends upon all the facts and circumstances in each
     case, including the good faith of the taxpayer.

Courts have likewise reiterated that intent is to be taken into

account, but they have nonetheless steadfastly adhered to the

principle that intent alone, divorced from actual use, will not

satisfy section 1034.   See United States v. Sheahan, 323 F.2d

383, 385-387 (5th Cir. 1963); Bayley v. Commissioner, 35 T.C.

288, 295-297 (1960).    As stated by the court in United States v.

Sheahan, 323 F.2d at 385:

     It is true that the good faith of the taxpayer is a
     circumstance to be weighed, and it may be the decisive
     factor in a close case in determining whether one of
     two houses is the principal residence, or whether the
     house is a residence, but there must be supporting
     facts to show that the taxpayer used the new property
     as his principal residence.
                               - 9 -

Thus, in general, courts have made clear that lack of actual

occupancy will thwart the attempts of even the most well-

intentioned taxpayer to utilize the deferment rules of section

1034.

          Application to Construction and Improvements

     More specifically, this focus on actual use does not shift

when examination turns to what courts and legislatures have had

to say concerning construction and improvements.    As indicated

above, section 1034 explicitly provides that capital expenditures

for construction, reconstruction, and improvements may be

included in the statutory cost of purchase.    However, to relieve

petitioners from the requirement that the separate structure be

put to some residential use within the prescribed time period

would be not only inconsistent with the history of the section,

but also illogical.

     As early as 1961, in interpreting the predecessor of section

1034 (section 112(n) of the 1939 Code), the U.S. Court of Appeals

for the Ninth Circuit concluded that “Congress intended to permit

the taxpayer to obtain the benefit, taxwise, only of so much of

the cost of construction of, or improvements to [emphasis added],

a new house as the taxpayer had constructed and used within the

eighteen month period herein applicable.”     Kern v. Granquist, 291

F.2d 29, 33 (9th Cir. 1961).   Since the 1939 Code provision, like

section 1034(c)(2), used the language “construction * * * and
                              - 10 -

improvements made”, the court further declared that “We cannot in

good conscience rewrite the statute as though it included the

words ‘contractual liabilities incurred during the 18 months

period.’”   Id.

     In contrast, petitioners here contend that the completeness

of the improvements is immaterial; rather, the only question is

the amount paid in connection with capital improvements during

the reinvestment period.   Section 1034 case law, however, fails

to support this view.   There are no reported cases permitting

inclusion of costs incurred for the construction of a separate

structure not yet placed in residential use.   Although in

Mitchell v. Commissioner, T.C. Memo. 1997-493, cited by

petitioners, the Court uses the terminology “commenced and/or

completed” in its discussion of whether the cost of renovations

could be included in a section 1034 calculation, the case is

distinguishable because the Court decided that the improvements

were not even commenced or paid for within the reinvestment

period.

     The case law has denied nonrecognition treatment where

expenditures were made for residential structures not yet

occupied.   For instance, in Elam v. Commissioner, 58 T.C. 238

(1972), affd. per curiam 477 F.2d 1333 (6th Cir. 1973), the

taxpayers sold their former residence and purchased property on

which they intended to build their new main residence and a guest
                               - 11 -

house.   Within the reinvestment period, they constructed and

moved into the guest house.   See id.   They also expended funds in

building the main house, but this structure was still under

construction and not yet occupied at the expiration of the

statutory period.   See id.   As a result, this Court refused to

allow costs of the main house to be taken into account for

purposes of section 1034, stating that the main house “possessed

no residential utility” and “was simply not put into use as a

residence before the prescribed time limit.”    Id. at 241.

     Although petitioners attempt to distinguish Elam v.

Commissioner, supra, on the grounds that the guest house and main

house in that case were separate residences, rather than two

structures intended as a single residence, this difference

becomes irrelevant in light of the precedent that both new

residences and mere additions or improvements must be placed into

residential use before section 1034 will apply.   Moreover, the

Court in Elam even addresses this multiple buildings issue.

While indicating that outbuildings and servient structures might

in some scenarios logically and functionally be classified as

part of a residence, the Court makes clear that an unfinished

structure intended for future dwelling performs no such logical

residential role.   See id.

     Poague v. United States, 66 AFTR 2d 90-5825, 90-2 USTC par.

50,539 (E.D. Va. 1990), affd. without published opinion 947 F.2d
                             - 12 -

942 (4th Cir. 1991), cited by petitioners, offers an example of a

situation where multiple structures were performing their logical

and intended function in support of a residence and, hence,

similarly emphasizes the importance of normal residential use.

     Still further illustrating the type of use necessary to

qualify a structure for section 1034 purposes, the court in

United States v. Sheahan, 323 F.2d at 387-388, declared even

planting shrubbery, putting up a mailbox, moving in boxes of

belongings, and occasionally eating lunch at a newly constructed

house to be only “token ‘use’” insufficient to satisfy the

statutory requirement that construction be used as a residence.

Likewise, in Bayley v. Commissioner, 35 T.C. at 295-296, the

Court refused to permit section 1034 to be used, despite the

taxpayers’ having moved in some furniture, where “the rather

extensive state of incompletion of the new residence-–no water or

sewerage connections, no appliances in the kitchen, and lights

and flooring only in minimal quantities–-effectively prevented

petitioners from living in the new residence.”   The Court in

Bayley particularly emphasized the taxpayers’ failure to sleep in

the new residence as indicative of the fact that they had not

begun to use and occupy it within the meaning of the statute.

See id. at 296.

     Here, petitioners’ new structure stood in a parallel state

of incompletion at the end of 1993 when the statutory period
                              - 13 -

expired.   Petitioners had never slept in the building at that

time.   There was no central heating.    The kitchen was being used

as a workshop to aid in the ongoing construction. The garage had

similarly been pressed into service as a workshop and used to

house construction tools.   Three of the structure’s major systems

were not even inspected by the City of Turlock and approved in

rough form until September of 1997.

     Thus, nearly 4 years after the expiration of the statutory

period, the residence could boast only rough electrical,

plumbing, and heating/ventilation systems.     Moreover, the

condition of a home with such rough systems is significantly

removed from what could be termed livable.     A rough electrical

system must include wiring, but not switches and fixtures.     A

rough plumbing system similarly denotes pipes and drain lines for

fixtures such as toilets and bathtubs, but not the fixtures

themselves.   A rough heating system has vents for a water heater

or furnace, but, again, need not have the actual heater or

furnace.   Here, the only evidence offered by petitioners that

their systems were in anything other than such rough form at the

close of the relevant period is testimony that a toilet and sink

had been installed in one bathroom.     Furthermore, photographs

taken in 1999 reveal that construction work remained in progress

in the intended living room, kitchen, great room, bedrooms,

bathrooms, laundry room, and art studio of the new structure.       In
                              - 14 -

contrast, pictures taken at the same time in the older home show

that petitioners’ furniture and household goods were still

located in the original building.   Consequently, we must conclude

that the new structure was simply not ready for residential

occupancy and was not occupied before the expiration of the

statutory period.

     Hence, the attempts of petitioners to comply with the

statute, like those of the taxpayers in Elam, Sheahan, and

Bayley, cannot be said to rise above the level of token use.   The

general incompleteness; the lack of major furniture, appliances,

and amenities; and the failure to sleep in the structure cannot

be overcome by petitioners’ minimal or workshop use of the

structure.   Thus, since petitioners simply have not placed the

new structure into use as part of their residence, a denial of

nonrecognition treatment is required.

     We therefore hold that petitioners are not entitled to defer

recognition under section 1034 of gain on the sale of their

principal residence.   Respondent’s determination of a deficiency

with respect to petitioners’ 1991 taxable year is sustained.

     To reflect the foregoing,


                                         Decision will be entered

                                    for respondent.
