Keys to Preparing a Like-Kind/Tax-Deferred Exchange Transaction
As a result of the budget crisis, the number of IRS and state audit notices received by individuals and businesses have been escalating like never before. With audits rising, taxpayers are required to be more cautious with their tax filings. Tax agencies are training their auditors to specialize in certain areas, including audits of "Like-Kind/Tax Deferred Exchanges" under Internal Revenue Code (IRC) Section 1031.
Increased Scrutiny of 1031 Exchanges
Both the Internal Revenue Service and the California Franchise Tax Board (FTB) have identified this transaction as one of the areas where taxpayer noncompliance has been found. In a 2007 compliance testing, the Government Accountability Office found that numerous taxpayers were misreporting like-kind exchange transactions. As a result, the Internal Revenue Service began to provide taxpayers with additional guidance regarding the rules and regulations governing the like-kind exchange. In addition, the California Franchise Tax Board placed 1031 exchanges on its top audit issues list and indicated their audit focus would be on basis calculations, timing rules and related party transactions. With 1031 exchanges still one of the top examined tax issues during audits, investors and business owners should be aware of the audit examination process and the general 1031 exchange rules.
It is crucial to first understand how a like-kind exchange qualifies as a tax deferral. As a general rule, tax must be paid when a business or investment property is sold. However, a like-kind exchange sale provides an exception and allows taxpayers to reinvest the sale proceeds to purchase similar property (replacement property), while deferring payment of taxes until the replacement property is sold. The replacement property must be identified within 45 days of selling the old property (relinquished property), and the exchange transaction must be completed within a maximum of 180 days. The main goal of taxpayers participating in a 1031 exchange is to defer the entire gain. The strategy to defer the gain is to "trade up."
In order to trade up, three general rules must be met. First, a taxpayer must purchase a property of equal or greater value than the old property. Second, the debt incurred in the acquisition of the new property must be of equal or greater value than the old property; and, finally, all exchanged funds must be reinvested to purchase the replacement property. If a taxpayer "trades down" – that is, cash, relief of debt or non-like-kind property is received – some gain will be triggered in the year of the exchange.
Due to the complexity of 1031 exchange transactions, tax authorities are examining the entire transaction and not just the exchange calculation. Although the exchange calculation provides an auditor a snap shot of the entire transaction, auditors are also closely examining all like-kind exchange documents to ensure the exchange qualifies for the deferral treatment. Taxpayers should be aware when participating in a tax-deferred exchange that these audits are common and seek professional advice before entering into the transaction.
Required Items for 1031 Audits
The following is a list of items and calculations generally requested in a like-kind exchange audit. The exchange worksheet calculation will reconcile the realized gain, recognized gain, recapture gain (portion of gain that is taxed at a higher rate), if any, and the adjusted basis of the new property, to the amounts reported on the tax return. The auditor will expect to see the replacement property's basis reduced by the deferred gain amount. Also, proof of the relinquished property's adjusted basis will be required to provide the original purchase documents and depreciation schedule to substantiate their basis calculation.
Another requirement is the exchange agreement and contracts with the exchange accommodator/qualified intermediary. This written agreement is examined to verify the taxpayer's assignment as a seller of the relinquished property and its sales proceeds, and the assignment as a buyer of the replacement property. In regards to the sales proceeds from the relinquished property, the agreement must provide instructions that limit the taxpayer from receipt of cash, pledge or ability to borrow funds until the completion of the exchange. If such limitation does not exist, the exchange will not qualify for deferral treatment.
The taxpayer will also need a 45-day identification letter. This letter is a signed written document that identifies the replacement property within 45 days after transfer of the relinquished property. This letter will not be required if the replacement property was completed within the identification period. The auditor will confirm that the exchanger met one of these identification methods and that the exchanger acquired the identified property.
Purchase and sale agreements will provide the auditor with terms and conditions of the relinquished property sold and the purchase of the replacement property. Mortgage loan agreements are also necessary. The auditor will review the old and the new debt to determine if a trade down exists.
The auditor will also want to see the transfer of title. The title is reviewed to ensure the owner (the exchanger) of the relinquished property is the same owner of the replacement property. It will also show the timing of the exchange. The timing of the exchange must be completed by the earlier of 180 days or the due date of the exchanger's tax return due date, including extensions. The exchange must be completed within this period. The clock starts ticking from the date title was transferred on the old property and ends upon receipt of the title from the new property.
Copies of escrow closing statements for the sale of the relinquished property and the purchase of the replacement property are also important. These escrow statements are examined closely to verify dates, value, debt relief and assumptions, transfer of excess cash or property and closing costs.
A statement showing the exchange account reconciliation for the funds transferred when the exchange transaction was complete must be generated from the exchange accommodator/intermediary. It will help the auditor determine if any cash or property was disbursed. If the full amount of the proceeds from the sale of the relinquished property is received before the purchase of the replacement property, the transaction will qualify as a sale instead of a deferred exchange.
The auditor will examine the requested documents outlined above to ensure they support the information reported on the tax return and to determine if the exchange qualifies for deferral treatment. Upon examining these documents, the auditor seeks consistency regarding timing, value, debt and equity of the properties exchanged, description of exchanged properties, assignment of the relinquished property sales proceeds, titleholders and transfer of escrow funds. The IRS and FTB auditors are very experienced in this area and are prepared to confront and challenge complicated exchange transactions. Most of these auditors have experience with reverse exchanges, build-to-suit exchanges and multiple property exchanges, in addition to the traditional 1031 exchanges.
Plan Properly with the Right Team
Like-kind exchanges can be a tax planning opportunity to defer taxes, and create additional equity for reinvestment purposes. However, there are other factors as to why an exchange may be of interest to an investor. The motive of participating in a 1031 exchange may be related to the replacement property's location, diversification, depreciable value, cash flow and marketability. Regardless of what the motive may be, careful planning is essential.
Deferred tax exchange transactions can be complicated, and it is recommended to seek advice from a qualified intermediary to safeguard the exchange funds, facilitate the exchange process and handle all of the paper work. Because the qualified intermediary cannot be the exchanger's tax or legal advisor, it is important to have the exchange intermediary and your tax advisor work together to better assist you in the 1031 exchange transaction.
The planning phase of a tax-deferred exchange consists of evaluating potential replacement properties and comparing the value and debt liability for the old and new property to determine if any portion of the gain is taxable. If the exchanger receives cash or nonqualified property when the exchange is complete, there is a possibility that some gain will be recognized in the current year. During the planning phase, it is also important to determine if any of the gain will be subject to recapture, which is taxed at a higher tax rate. Also, if multiple properties are in place, consider each property separately as opposed to looking at the exchange as one single transaction. Planning ahead can avoid unexpected gains or a failed like-kind exchange transaction.
Investors and business owners should not be wary of like-kind exchange transactions. However, it is important to be informed and aware that tax authorities may analyze the transaction closely. Involving your tax professional and an exchange intermediary, as well as keeping proper documentation of the exchange transaction, is essential in a tax deferred exchange transaction. In the event of an audit, you will be well positioned if your transaction has been carefully planned and documented. Audits can be very time consuming and costly, especially if your transaction is challenged. Good planning and involvement of professionals can minimize headaches in the future.