Avoid Audits for Tax-Deferred Exchanges

Posted on: June 21, 2007

It’s starting to happen. While historically tax-deferred exchanges have not been a target for audit by the Internal Revenue Service, we are now hearing from tax professionals that more exchanges are being audited. This is particularly true for high-income Taxpayers with complicated real estate transactions. You can avoid this uncomfortable situation by knowing what the IRS auditors are being told to look for if they find an exchange on the tax return. The following is a short list of those audit points.

Relinquished and Replacement Properties

1. How did the Taxpayer use the relinquished property and replacement properties? Personal use as a second home or principal residence does not qualify. Properties held “primarily for sale” – builder/developer/rehab properties do not qualify.
   
2. How long did the Taxpayer hold the relinquished and replacement properties?
   

Exchange Documentation

1. Is there a written exchange agreement? This is required even for a “simultaneous” exchange.
   
2. Review the agreement closely. Many forms are seriously defective.
   
3. Verify that the agreement was executed prior to closing of the sale. Watch for documents that are “as of” dated.
   
4. Review all closing documents. Do they conform to the exchange documents?
   
5. Does the agreement specifically require the Taxpayer to identify replacement property that “qualifies” under §1031?
   
6. Does the agreement contain the (g)(6) restrictions? These restrictions prohibit Taxpayer from receiving exchange funds prior to a technical exchange termination event.
   
7. Do the (g)(6) restrictions apply to interest earned on the exchange account?
   

Identification of the Replacement Property

1. Carefully review the identification document. The 45-day identification period is the most difficult part of the exchange process for the Taxpayer. Be vigilant for fraud.
   
2. Is it dated “as of” a particular date?
   
3. Verify which ID rule was used? 3-property? 200% rule? 95% rule? Does the ID meet the specific requirements of the rule? Be aware that the Taxpayer may have identified properties beyond those showing on the offered evidence.
   
4. Does the identification “unambiguously” identify the replacement properties?
   
5. Does it accurately describe the properties? Correct legal description? Correct street address? Correct percentage of ownership? Were improvements identified? Any error could invalidate the identification and therefore the exchange.
   
6. Did the proper Taxpayer sign the identification? Individual? Trustee of a trust? Officer of a corporation?
   

Acquisition of the Replacement Property

1. The 45-day and 180-day deadlines are counted from the date the benefit and burdens of ownership shift to the Buyer. This is not necessarily the same date the deed records. Day 1 is the day after the benefits and burdens shift.
   
2. These deadlines are easily miscalculated. They are counted as calendar days, not business days, so all Saturdays, Sundays and holidays must be included.
   
3. Was the replacement property acquired within the 180-day exchange period?
   

Exchange Funds

1. Did the Taxpayer receive cash or other non-qualified property?
   
2. Was the cash or non-qualified property received prior to a (g)(6) termination event? Did they have the right to receive the cash or non-qualified property prior to a termination event?
   
3. Did the Taxpayer earn interest on the exchange funds? Did the Taxpayer pay tax on the interest?
   
4. Was the interest received prior to a (g)(6) event? Did they have the right to receive interest prior to a (g)(6) event?
   
5. Did the Tax payer pay transactional costs beyond what is typical and ordinary under local closing practice?
   
6. Review prorations that might violate the (g)(6) restrictions.
   

Related Parties

1. Did the Taxpayer buy the replacement property from a related party?
   

As always, urge your client to consult with their tax and legal advisors to make sure their exchange will survive the test of an IRS audit.

Article written by Toija J. Beutler, Esq., Sr. Vice President/NW Regional Manager for IPX1031. IPX1031 is a national leader in 1031 tax-deferred exchange transactions and is a wholly-owned subsidiary of the nation’s largest title insurance underwriter. For more information on our services and the value we bring to your real estate investor, please call our Portland Office (503) 223-3911 or (888) 310-1031.