1031 exchanges are among the most closely scrutinized tax issues for auditors – they are widely used and frequently misused, with many investors running afoul of the rules.
In this blog post, we will outline the main reasons for most 1031 audits, and what to look out for under the new tax law.
Most of our 1031 exchange audit work has involved the following issues:
Technical requirements of 1031 exchange not met
The most obvious red flag for an audit in connection with a like-kind exchange under 26 U.S. Code § 1031 is the failure to meet one or more of the rule’s technical requirements. For example, the property exchanged must be of like kind, the property must be used in a trade or business or for investment, the time limitations for identification of a replacement property and exchange must be adhered to, the replacement property must be of equal or higher value than the relinquished property, and any “boot” must be reported.
Problems with qualified intermediaries
A qualified intermediary is defined under Treas. Reg. §1.1031(k)-1(g)(4) as a person who is not the taxpayer or a disqualified person, who enters into a written agreement (the “exchange agreement”) with the taxpayer and:
- Acquires the relinquished property from the taxpayer,
- Transfers the relinquished property,
- Acquires the replacement property, and
- Transfers the replacement property to the taxpayer.
The IRS is clear about who cannot be a qualified intermediary. A qualified intermediary in a 1031 exchange may not be anyone who has acted on the taxpayer’s behalf when dealing with a third party (their “agent”) during the previous two years – this includes their attorney, CPA, realtor, investment advisor, employee, and others.
Use due care in your choice of qualified intermediary – make sure that you use someone not only trustworthy but also well versed in the intricacies of section 1031.
Sourcing of gains
Deferred gain from relinquished property located in California must be sourced to California regardless of the location of the replacement property or the residence of the taxpayer. The Franchise Tax Board (FTB) has been clamping down on California real estate investors — all taxpayers who have completed a 1031 exchange in California since 2014 must file an information return to help the state keep track of California sourced gains.
Section 1031 partnership transactions
The IRS is closing gaps and loopholes in its treatment of 1031 exchanges and there is a particularly high audit rate for partnership 1031 transactions. The IRS carefully examines partnership 1031 exchanges, including assignment language in purchase contracts and how funds are secured to accommodate exchanges in the state. Failing to meet federal and state requirements can result in civil and/or criminal penalties.
Impact of the new tax law
The Tax Cut and Jobs Act of 2017 (TCJA) made a significant change to 1031 exchanges – while real estate may still receive this favorable tax treatment (and is subject to the same rules as under previous law), tangible and intangible personal property no longer qualify. We recommend that you discuss with your tax attorney the possibility of the full expensing of any personal property assets that you use for business purposes.
Consult a 1031 Exchange Lawyer
To prevent unintended tax consequences, it is crucial to strictly adhere to 1031 procedures.