1031 Exchanges Targeted for more audits by IRS and states

Section 1031 of the Internal Revenue Code allows a taxpayer to roll the gain from the sale of their Old Property over to their New, provided they do certain things which are set out by the code. Most people seem to miss (or perhaps simply don’t understand) that Section 1031 is a “form driven” code section. This means you must do exactly what the code section requires. If you don’t, your exchange will be disallowed in an audit. In other words, you must dot the i’s and cross the t’s.

Over the years, I’ve seen a lot of bad exchanges sneak by only because they didn’t get caught. For example, I saw a bank intermediary on the west coast handle an exchange for a well-known member of the movie industry without a set of exchange documents. I saw another intermediary tell their clients that they can wait to submit their 45-day list on Monday if the 45th day falls on a Saturday or Sunday. I know of an intermediary that uses “a copy of a copy” of an exchange agreement that’s been obsolete since 1995, and there are rumors in the industry of a good-sized intermediary on the west coast that has never filed tax returns for the reverse exchanges it has handled. All of these examples are grounds for immediate disallowance of the exchange. Each example indicates a problem that has probably affected even more of the exchanges they’ve handled.

...They paid taxes on 15 million dollars. But hey! they saved a hundred bucks...!

Part of the problem is the fault of the industry: there are no standards or basic requirements for qualified intermediaries. You don’t have to take a class or pass a test to be an intermediary. As a result, there are people handling exchanges that simply aren’t trained to do so.

Another part of the problem lies with the client/investor. Most people doing an exchange are more concerned about the price tag on the exchange fee than the quality of the exchange or the experience level of the intermediary. There seems to be a prevailing belief by the public that to have a good exchange you simply need a set of paperwork (and any ol’ set will do). As long as you have some kind of paperwork, your exchange will be blessed. A couple of years ago, a potential client took his $15 million exchange to a competitor who quoted a fee $100 less than ours. The intermediary had only been in business a few months and used a bad set of fill-in-the-blank exchange documents. The exchange was subsequently disallowed because of problems with their documents. The price-shopper paid taxes on 15 million dollars. But hey! they saved a hundred bucks!

Finally, part of the problem lies with the IRS and the states. The IRS hasn’t had a specific policy to target 1031 exchanges for audit. Until now, very few exchanges have been audited. The ones that have were in tax returns audited for other reasons. The exchange was looked at simply because it was there.

All of that is about to change.

Earlier this year, the Treasury Inspector General for Tax Administration reviewed the IRS’s handling of 1031 exchanges, and chided them for exercising such minimal oversight of the exchange process. The report noted that there are currently six large exchanges with a combined assessed deficiency of $873 million! In other words, if the big dogs aren’t following the rules, how bad must the smaller exchanges be? In response, the IRS promised that it will begin a 1031 exchange-auditing program.

The states are waking up to 1031 exchanges also. Minnesota has adopted a policy of auditing 100% of all 1031 exchanges appearing in Minnesota tax returns. The state has identified at least one Minnesota intermediary that it considers to be so bad that they have an agent permanently camped in their office. More cash-strapped states are bound to follow Minnesota’s lead when they figure out that 1031 exchanges are a golden honey pot.

States are getting into the legislative act as well, requiring intermediaries to be licensed and to demonstrate a minimal level of competency and education. Colorado will most likely introduce such a bill when the legislature meets in January. Nevada recently passed such a law, and California, Washington and Georgia are looking at similar legislation.

What does all this mean to you, the consumer? As with most things, there’s good news and bad news. The good news is the bar will be raised. Intermediaries you deal with in the future will be a lot more knowledgeable and ethical. The bad news is there will be a much smaller pool of intermediaries to choose from. Their fees will be higher than they are now, and will be about the same across the board.