The 26 U.S. Code § 1031 – aka the 1031 exchange or like-kind exchange – can be a good strategy to help defer capital gains taxes on the sale of real property. But as mentioned in a previous blog, very stringent rules exist when it comes to conducting this type of exchange. Playing fast and loose with in-stone deadlines, property values, or other factors could wave a red flag at the IRS.
How often does the IRS audit these exchanges? There really isn’t a specific likelihood of auditing for a 1031 exchange. But paying attention to the following could potentially reduce the likelihood of such an audit.
The main foundation of a 1031 exchange is that like property is swapped for like property. But “like-kind” doesn’t mean “same.” In other words, you don’t have to exchange a duplex into another duplex, or a retail center into another retail center. In this case, “like-kind” means exchanging a property used for business or investment purposes into another such property. So you could swap that duplex into an apartment building—as long as both properties are designated for trade or investment purposes.
One issue the IRS pays attention to when auditing is whether you’ve followed the very, very strict deadlines:
The issue to remember here is that these deadlines are calendar-based, not “work-week” based. If a deadline falls on a weekend or holiday, it still counts. There is no wiggle room. Failure to adhere to even one deadline could cost you that capital gains tax deferral.
An IRS auditor will check a written “designation of properties” notification to ensure that the number of replacement properties complies with the rules. These are:
If your replacement property/properties don’t fall into any of the above categories, the IRS could disallow your exchange.
The QI is another “must-have” when it comes to your exchange. And yes, the IRS will check to be sure you used one during an audit. That QI shouldn’t have a specific relationship with you (as in, no relatives or agents can act as your QI). Additionally, the QI you select must have Qualified Intermediary status, which involves receipt of a QI-EIN.
The same entity that puts the relinquished property on the market should be the same one that receives the replacement property. For example, if your partnership swaps the relinquished property, that same partnership must take ownership and title of the replacement property. Such discrepancies might raise IRS eyebrows and trigger an audit.
According to CCIM Magazine, the following could also trigger closer IRS examination or an audit of your exchange:
This doesn’t mean that you can’t use these for an exchange. But these actions could trigger an audit. The IRS could also audit your exchange years after closing, to ensure you don’t fall out of compliance. This might include converting your property from business or investment to personal use.
Is your 1031 exchange in danger of an audit? There’s no specific information available about “how often” this might occur. But be sure to follow the IRS’s rules to the letter if you participate in a like-kind exchange. Failure to do means an audit could lead to potential disallowance and an unexpected tax bill.