1031 Exchange Tax Audits

1031 exchanges are among the most closely scrutinized tax issues for auditors. They are widely used and frequently misused, with many investors running afoul of the rules. The Moskowitz, LLP tax lawyers have represented thousands of taxpayers in IRS and state audits, and have litigated hundreds of tax cases. Audit representation requires intimate knowledge of tax law and in depth knowledge of taxpayer’s rights.

In the case of audits surrounding 1031 exchanges, extensive knowledge of real estate investment strategies is also required. Most of our 1031 exchange audit work has involved the following issues:

 

Technical requirements of 1031 exchange not met

The most obvious red flag for an audit in connection with a 1031 exchange is the failure to meet any of the rule’s technical requirements. The property exchanged must be of like kind, the property must be used in a trade or business or for investment, the time limitations for identification of a replacement property and exchange must be adhered to, the replacement property must be of equal or higher value than the relinquished property, and boot must be reported, among other things.

 

Problems with qualified intermediaries

The IRS is clear about who cannot be a qualified intermediary. A qualified intermediary in a 1031 exchange may not be anyone who has acted on the taxpayer’s behalf when dealing with a third party (their “agent”) during the previous two years – this includes their attorney, CPA, realtor, investment advisor, employee and others. You must use due care in your choice of qualified intermediary – make sure that you use someone not only trustworthy but also well versed in the intricacies of section 1031.

 

Sourcing of gains in California

Deferred gain from relinquished property located in California must be sourced to California regardless of the location of the replacement property or the residence of the taxpayer. The Franchise Tax Board (FTB) has been clamping down on California real estate investors -- all taxpayers who have completed a 1031 exchange in California since 2014 must file an information return to help the state keep track of California sourced gains.

 

Section 1031 partnership transactions

The IRS is closing gaps and loopholes in its treatment of 1031 exchanges and there is a particularly high audit rate for partnership 1031 transactions. The IRS carefully examines partnership 1031 exchanges, including assignment language in purchase contracts and how funds are secured to accommodate exchanges in the state. Failing to meet federal and state requirements can result in civil and/or criminal penalties.

 

Consult a 1031 Exchange Lawyer

Like-Kind Exchanges under IRC §1031 (a four part blog series)

To prevent unintended tax consequences, it is crucial to strictly adhere to 1031 procedures. The Moskowitz, LLP tax group provides the highest level of tax representation for denial of 1031 tax benefits and for audits connected with 1031 exchanges. Call our California office at (888) 829-3325 or (415) 394-7200.

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