What Does The IRS Look For When They Audit a 1031 Exchange?

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.

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!  

The 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.