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What
Does The IRS Look For When They Audit a 1031 Exchange?
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We
get this question all the time,
"What will the IRS look for if they audit my
exchange?" A 1031 Exchange is reported on form
8824, "Like Kind Exchanges," and attached
to the taxpayer's tax return. Section 1031 of the
IRC actually has two parts, real estate and personal
property exchanges. Regarding real estate, a 1031
exchange joins together the sale of Old Property
with the purchase of New for the purpose of deferring
taxes. In today's appreciating real estate market,
the deferred tax savings can be significant, so
rest assured the IRS will examine the whole transaction
in an audit, not just numbers and dates.
The first thing they look at is the type of properties
exchanged. Both the Old and New properties must
qualify as investment or business use. Land always
qualifies, as does rental property. Not clearly
stated in section 1031 is how long you must hold
the property before exchanging it. Answer: One year
and one day. So, if you're thinking of buying a
fixer-upper, making improvements and flipping it
in less than a year, consult with your tax accountant
before doing an exchange.
Next,
it is mandatory the taxpayer use a Qualified Intermediary
(QI) to prepare the legal documents for the exchange
and to hold the money in between the sale of the
Old Property and the purchase of the New.
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As
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by
Nace Cohen
Manager at
The 1031 Exchange Experts |
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In
traditional IRS fashion, they don't explain who can be
a QI; rather, they define who cannot. In effect, anyone
who has had an agency relationship with the taxpayer in
the previous two years is disqualified. This knocks out
a whole bunch of folks, like the taxpayer's CPA, attorney,
realtor, title agent, investment advisor, employee, or
friend. When considering a 1031 exchange, use due care
when choosing your QI, don't try to do it yourself or
use someone who isn't well versed in Section 1031.
In an exchange, title transfer dates start and end the
clock, not contract dates. From the date of closing
on the Old Property, you'll have 45 days to identify
and 180 days to close on New Property. You can identify
up to three replacements without price limitations.
When identifying, you report to the QI property you
intend to buy. The IRS will need to verify how and when
you identified, as well as when you closed on the Old
and New properties. Note: There are no extensions on
the 45 and 180 day limits, and we're dealing with calendar
days. This means if day 45 falls on a holiday and you're
QI is not available to receive the identification form,
you've got a problem and your exchange could be toast!
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IRS is very particular about these dates and will review
them closely during the audit.
In
the next phase of the audit, the IRS "follows the
tax return" to ascertain if the taxpayer who sold
the Old Property is on title to the New. Many exchangers
trip on this. For example, if the taxpayer sells property
in their own name and buys new property in a partnership
or corporation name, the exchange will be disallowed!
Last, in order to pay no tax, all the cash generated
from the sale of the Old Property must be reinvested
in New Property, and the taxpayer must buy a property
of equal or higher value than the property sold. Any
cash, or "boot" taken during the exchange
would be taxable. Buying property less than the value
of the one sold is taxed as a "buy down."
The IRS will examine the closing statements on the sale
and buy to calculate these amounts.
The rules governing section 1031 are truly easy to follow.
Reinvesting the tax you otherwise would have paid on
the sale of the Old Property is a tremendous advantage
the government allows you to take. Just be sure to use
the guidance of an expert QI in your exchange so no
mistakes are made along the way. |
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