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October 11, 2007

The Wall Street Journal yesterday had a piece that said the IRS is going to be stepping up scrutiny of Section 1031 "like-kind" exchanges in the wake of a Treasury Inspector General for Tax Administration report. The TIGTA report had urged increased IRS attention to Section 1031 swaps.

It seems to be getting more difficult to work Section 1031 deals. Most like-kind exchanges involve real estate. In the old days, many folks selling investment property would acquire farmland as the replacement property, but the soaring cost of farmland has taken a lot of the fun out of that. "Tenant-in-common" deals, where taxpayers would take an undivided interest with up to 29 other folks in, say, a net-lease building as the replacement property, are often seen as expensive and inconvenient. This makes it tempting to cut corners to get a deal done some other way. Other taxpayers decide that the 15% capital gain rate is low enough that they just take the cash and pay the tax.

I would expect the IRS to focus on a few areas as they put swaps under their microscope:

- Was the property given up held for investment or for use in a trade or business? Section 1031 doesn't work for personal use property. If you used the property given up for personal use - say, as a vacation home - the IRS isn't going to like it (see here, for example).

- Will the replacement property be used for investment or a trade or business?

-Were the properties given up and received held long enough to qualify? The properties have to be "held" for use in a trade or business. You can't "flip" properties under Section 1031. While it is not clear how long you have to "hold" property to qualify for an exchange, you shouldn't expect to swap property you've held less than a year or two.

- Was the property land inventory? If you are a developer and you hold property for development and sale, rather than investment, it doesn't qualify. If you change your mind on why you hold the property, you need to make sure you document that you've changed your mind, and then you need to wait a decent amount of time before the swap.

- Was the "swap" closed by acquiring property from a related party? This can kill the whole deal, especially if an intermediary is used and the property given up doesn't go to the related party (see here, for example).

- Were intermediaries or escrows used properly? Most Section 1031 deals use an intermediary or a qualified escrow to hold the funds received on the sale of the disposed property while the replacement property is found. The tax law has very strict requirements on how these are to be used. Once the cash reaches your hands, it's probably too late to do a swap.

- In a delayed swap, were the 45-day identification and 180-day closing requirements met? You have 45 days to identify a replacement property after you sell your original property, and 180 days to close. There is no wiggle room; if you don't properly identify the property until day 46, or if you close on day 181, you are out of luck.

If you qualify for a Section 1031 deal, and the economics work, the new IRS scrutiny shouldn't deter you. But do take extra care that you are well-advised on how to do the deal, and that you follow the formal rules religiously.

Hat tip: The TaxProf.

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