If you are considering a 1031 exchange (also known as a “Starker exchange”), you better make sure that you do it right. The Internal Revenue Service plans to increase its audits and its enforcement of these exchanges by the summer of 2008.
Usually, when a taxpayer sells a business or investment property, the taxpayer must pay a tax on any profit that is made. If the property was owned for more than one year, it will normally be considered a long-term capital gain and the tax will be based on your income. Currently, the highest tax rate is 15 percent.
However, if the taxpayer engages in an exchange, and strictly follows the complex rules, this gain can be postponed. For example, if you purchased your investment property for $100,000 and sold it for $200,000, you would in most cases have to pay the IRS $15,000 in addition to any state or local tax. However, if this property was sold in connection with a Starker exchange and you obtained another investment property worth $300,000, you would not have to pay any capital gains tax. Instead, the basis of the old property would be transferred to the new one; you would have to pay the tax only when you ultimately sold the replacement property and did not engage in yet another 1031 exchange.
But you must understand that a 1031 is not a “tax-free” process; it only defers the time when you have to pay the capital gains tax.
In a report issued last month, the Treasury Inspector General for Tax Administration (TIGTA) advised the IRS that “there appears to be little IRS oversight of the capital gains (or losses) deferred through like-kind exchanges.”
When a taxpayer engages in a 1031 exchange, he or she must file Form 8824 with the IRS for the year in which the exchange took place. The Inspector General reported that more than 338,500 forms were filed in 2004 (the year of the TIGTA’s study). This amounted to deferred gains or losses of more than $73.6 billion. According to the report, “while this represents a doubling of the number of like-kind exchanges reported in 1998, the total dollars amounts deferred more than tripled.”
Like-kind 1031 exchanges serve a valuable function. According to the TIGTA report:
Taxpayers who take advantage of like-kind exchanges increase their purchasing power, as well as their financing and leverage capabilities, because payment of federal tax on the gains is deferred … with additional equity to reinvest, taxpayers can execute exchange after exchange to create a pyramiding effect. The tax liability may be forgiven upon the death of the investor because the heirs may qualify for a stepped-up basis on the inherited property.
But because of the lack of enforcement by the IRS, taxpayers have been taking advantage of these favorable tax rules. For example, the Government Accountability Office (GAO) conducted a similar survey and found that taxpayers often made misrepresentations of the assets that were being exchanged. In order to have a successful 1031 exchange, real property must be exchanged for like-kind property. While this is a very broad category — you can exchange a single-family investment property for raw land, an office building for a shopping center, or a condominium unit for a cooperative apartment — the exchange will not be accepted if you want to exchange your principal residence for some other kind of property. Nor can you exchange a business for real property: it is not “like-kind.”
However, the Inspector General discovered that the IRS generally will not impose any penalties if a taxpayer does not file Form 8824.
The report also highlighted other abuses, such as related party exchanges, incorrect basis figures, and partial, step and bartering exchanges. These are highly complex technical issues that will not be discussed or explained in this column.
Based on its findings, the Inspector General made three specific recommendations, all of which have been accepted by the IRS.
1. The IRS should study tax-reporting and compliance issues involved with like-kind exchanges The IRS agreed to conduct research studies and complete its work by Aug. 15, 2008. Based on the outcome of this research, it appears likely that exchanges that take place this year will be given greater scrutiny.
2. The IRS should provide better information and guidance to taxpayers on how to conduct a proper 1031 exchange. The IRS has agreed that by Jan. 15, 2008, it will provide more information on a number of its publications and forms so as to assist taxpayers in understanding how the exchange process works. Specifically, Publication 17 (entitled Your Federal Income Tax) will be updated to specifically remind taxpayers that they must file Form 8824 with their income tax return if they have been involved in a 1031 exchange during the previous year.
3. The IRS must provide clear guidance to taxpayers regarding the rules and regulations governing like-kind exchanges with respect to second and vacation homes that were not used exclusively by owners.
This is an area that is extremely complex. According to the Inspector General, “the absence of clarification on this issue leaves unrebutted the sales pitch of like-kind exchange promoters who may encourage taxpayers to improperly claim deferral of capital gains tax by selling nonqualified second and vacation homes through ‘tax-free’ exchanges.”
Here, too, the IRS agreed. By March 15, 2008, the IRS will provide additional information to consumers and to tax practitioners about the filing requirements for Form 8824. More importantly, the IRS will increase its “consumer warnings” so as to caution taxpayers to be “wary of individuals promoting improper use of like-kind exchanges.”
The IRS will not discourage the use of the Starker exchange. This process is specifically authorized in Section 1031 of the Internal Revenue Code. But investors must be on their guard against deceptive and fraudulent promotional schemes. Keep in mind that a Starker exchange is not a “tax-free” exchange; it is a “tax-deferral.” If done properly, it will allow the taxpayer to use the moneys that otherwise would go to Uncle Sam for additional investments.
If you plan to get involved in a 1031 exchange, you should make sure your own lawyer and accountant review the process at every step.
In fact, depending on the amount of your gain, it may be best to just pay the capital gains tax and not become a landlord on the new replacement property. Your financial advisors will be able to assess and assist you in making this important decision.
(Note: The entire report can be located on the Web at www.tigta.gov; click on 2007 audit reports. It is report 2007-301-72).