Predictions of Things to Come for 1031 Exchanges

Around the end of most years I write a column predicting what you are likely to see in the 1031 arena over the following 12 months. I recently spent an afternoon in a meeting with one of the people responsible for Section 1031 of the tax code for the IRS. Based on that meeting, what follows are my predictions of changes to look for during the next year.

Tightening of the requirements for qualified intermediaries -The IRS knows that they have problems with what they call “Accom-modating Accommodators.” These people are qualified intermediaries (QI) who are pretty loose with the requirements of a 1031 exchange. The problems range from these QIs regularly allowing clients to do 1031 exchanges on fix-and-flips, to their allowing clients to change their identification letter after the 45th day. The IRS knows they are out there, but it is not always easy for them to tell who these intermediaries are.

The IRS has been trying to figure out how best to deal with the problems during the last few years and now they have a plan. Intermediaries will be assigned a registration number similar to what tax shelter promoters must have. The IRS will use this number to track the exchanges each intermediary performs. This new procedure will require the revision of several IRS forms. You'll probably see a change to Form 1099-S but perhaps not until 2006. This form is used to report the sale of your Old Property. I expect that they will develop a new form for the reporting of sales subject to an exchange. Don't be surprised if they require that the intermediary's registration number be shown on the 1099-S along with some basic information like the date of closing and the dollar amount of proceeds sent to the intermediary.

Ò...this is what has the IRS concernedÑ they suspect (and rightfully so) that many TIC deals will not qualify as 1031 property....Ó

1031 Exchanges affecting Farmers - Congress and the IRS have been getting a lot of complaints lately about a sharp increase in the price of farmland. Apparently farmers blame a lot of this increase on 1031 exchanges. These higher prices have increased the entry-level requirements for new farmers, and these farmers are voicing their frustrations to their elected representatives. Farmers have a lot of political clout in this country; so I wouldn't be surprised if we see some federal legislation come out of this.

Changes affecting TICs - The last major change I see coming in the next year is some type of ruling or legislation designed to curb the rising occurrence of investments in Tenancy-in-Common (TIC). TICs are syndicated investment programs designed to attract investors into real estate projects--typically large projects.

Perhaps curb is too strong a word. But they will most likely do something. The TIC ruling that was written in 2002 (IRS Revenue Procedure 2002-22) was a listing of the minimum criteria that the IRS wanted to see before they would agree to rule on whether the project was approved as replacement property for an exchange. Estimates from the TIC industry are that the equity (or cash) portion of these purchases during 2005 will approximate $8 billion. If you assume that the average project involves 50% debt, the amount of real estate purchased during 2005 will approximate $16 billion. This is a huge increase from about $6 billion last year.

This expected increase of almost 300% this year is what has the IRS concerned. If you take 2004 and 2005 together, $22 billion is a lot of property, and at the industry estimate of $500,000 per investor, this is a lot of 1031 exchanges that are buying TICs as replacement property. So how many of these projects have actually applied for approval by the IRS? Two! And this is what has the IRS concerned--they suspect (and rightfully so) that many of these deals will not qualify as 1031 replacement property if they were audited.

The SEC is also concerned because they believe about half of the projects that were sold this year were sold by people who were not authorized to sell securities, people such as real estate agents who believe that what they are selling is real estate, not a security. And just so that no one is left out, Congress is also concerned because they are getting angry calls from Real Estate Investment Trusts (REIT) that are complaining that they can't buy any properties because the TICs are outbidding them. So, watch for some type of change to come in this area.