For taxpayers owning investment property or business owners with personal property considering a 1031 exchange, the first step is to visit your CPA to determine the tax consequences. Without knowing the tax before initiating the exchange, the taxpayer is assuming it makes sense to initiate the 1031 exchange. All too often taxpayers want to initiate an exchange without knowing the value or the reason to exchange other than to exchange for another property. That in itself is a good reason to exchange but for those taxpayers who want to justify the exchange expense, a 1031 exchange should start with a review of the realized gain on the sale.
Andy Gustafson
IRS Penalty for Disallowed 1031 Exchange
In a 1031 exchange, a qualified intermediary (QI), accommodator or facilitator is engaged to provide exchange documentation and hold the exchange proceeds in an escrow account under the taxpayer’s tax identification number. Advice is provided to qualify the transaction as a 1031 exchange. For those accommodators who are not CPAs or attorneys, care must be given not to provide specific tax advice which subjects the accommodator to Circular 230 enrolled as agents who practice before the Internal Revenue Service. The QI is similar to a flagman warning a taxpayer driving along at 70 mph before a curve that the bridge not in view is out. Determining how to navigate the bridge is up to the taxpayer’s tax counsel, including their CPA and or tax attorney.
IRS Penalty Standards
When a 1031 exchange is audited and disallowed, the penalty standards include the income tax related to the sale of the relinquished property and the penalty and interest imposed on the underpayment of taxes, which is equal to the federal short term rate plus three percent. The accuracy related penalty is equal to 20 percent of the substantial understatement of the tax. A substantial understatement is defined as the greater of $5,000 or ten percent of the recognized gain.
Should the taxpayer have substantial authority for the disposition taken, the penalty can be avoided. Substantial authority is defined in Regulation Section 1.6662-4(d)(3)(iii) and based on the following:
(i) The Internal Revenue Code and other statutory provisions
(ii) Proposed, Temporary and final Regulations construing such statutes
(iii) Revenue Rulings and Revenue Procedures
(iv) Tax treaties and regulations thereunder and Treasury Department and other official explanations of such treaties
(v) Court cases
(vi) Congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports and floor statements made prior to enactment by one of a bill’s managers
(vii) General Explanations of tax legislation prepared by the Joint Committee on Taxation
(viii) Private Letter Rulings and Technical Advice Memoranda issued after October 31, 1976
(ix) Actions on Decisions and General Counsel Memoranda issued after March 12, 1981 (as well as General Counsel Memoranda published in pre-1955 volumes of the Cumulative Bulletin)
(x) Internal Revenue Service information or press releases
(xi) Notices, Announcement and other administrative pronouncements published by the Service in the Internal Revenue Bulletin.
The penalty can be avoided if the relevant facts are adequately disclosed on the tax return and there is a reasonable basis for the position per Regulation Section 1.6662-4. In addition, the penalty can be assessed if there is negligence or disregard of regulations or rules per I.R.C. Section 6662(b). The taxpayer must maintain sufficient records to support their positions.
A fraud penalty is imposed of 75 percent of the underpayment if determined that taxpayer’s intent was to willfully evade the tax or to mislead.
I.R.C. Section 6701 levies penalties on persons who assist in the preparation of any portion of the taxpayer’s return knowing that such portion may result in an understatement of the tax liability. A $1,000 penalty is imposed; however, should a corporation tax return be subject to penalties, a $10,000 fine is assessed.
From a QI’s perspective who is not subject to Circular 230, knowing and acting within the boundaries of exchange advice is critically important. Telling the client they cannot provide tax advice protects the client and themselves. Taxpayers need to know the difference of what to expect and what not to ask. Ignorance is no excuse.
Should you like to receive “Taxpayers 1031 Checklist” inclusive of a checklist of 1031 issues to consider, click here for your free five page eBook.
Like-Kind Exchange of Radio and TV Stations
In the United States, a taxpayer normally incurs a capital gains tax obligation upon the sale of property if the taxpayer realizes a gain as a result of the sale. Because the capital gains tax rate is typically high taxpayers look for ways to reduce, or eliminate, paying capital gains taxes. One option is to enter into a Section 1031 Exchange transaction in lieu of a traditional sale. For transactions that qualify, any capital gains tax that would otherwise be incurred is deferred.
1031 Exchange Accommodator
The role of the 1031 Exchange Accommodator otherwise known as a Qualified Intermediary, or QI, is to facilitate Internal Revenue Service (IRS) Code Section 1031 exchanges. The Regulations created four safe harbors for the purpose of determining whether or not the taxpayer has actual or constructive receipt of money or property while engaged in a 1031 exchange. Given the 1031 exchange utilizes one of the four safe harbors, the exchange will not be challenged by the IRS from the perspective of constructive receipt.
Leasehold Improvement Tax Court Cases
Traditionally, the sale of real property exposes a taxpayer to a capital gains tax obligation if a gain was realized from the sale. Given the fact that capital gains tax rates have historically been high, taxpayers frequently look for ways to decrease or avoid paying capital gains taxes. One option allowable under the Internal Revenue Service Code is to enter into a Section 1031 Exchange in lieu of a traditional sale which results in a deferral of capital gains taxes. Section 1031 of the IRS Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.” For an exchange to qualify, the properties involved must be of “like-kind”. Not surprisingly, the definition of “like-kind” has been debated, argued, and expanded on by the Tax Court over the last 100 years in an attempt to decide whether the various transactions taxpayers have presented as Section 1031 Exchanges actually qualify. One variant of an Exchange that continues to result in confusion and litigation is the “leasehold Improvement” exchange.
Leasehold Improvements
A leasehold improvement involves modifications or renovations made to an existing building or piece of land that are made specifically to accommodate a business. Often, a taxpayer purchases a building or tract of land and then builds on the land or renovates the building to suit the taxpayer’s business purposes. If leasehold improvements are part of a proposed Section 1031 Exchange, they can complicate the analysis. This is particularly true if the taxpayer already owns the land on which taxpayer wishes to make the improvements prior to entering into the Section 1031 Exchange.
As a general rule, the I.R.S. has specifically disallowed attempts to use improvements of land already owned by taxpayer in a Section 1031 Exchange because a taxpayer cannot own both the property to be relinquished and the property used to replace it. Rev. Proc. 2004-51 Section 4.05 states “An exchange of real estate owned by a taxpayer for improvement on land owned by the same taxpayer does not meet the requirements of Code Section 1031.”
How a 1031 Exchange Works
For many first time sellers of investment real estate, personal property or equipment held in a business, understanding a 1031 exchange can be a bit of a challenge. Each 1031 exchange is different and dependent upon the characteristics of the taxpayer and transaction. The Internal Revenue Code Section 1031 has many rules and restrictions that for the novice investor and qualified intermediary can be problematic if not facilitated correctly.