Can 1031 Exchanges be Subjected to Audits?

When it comes to tax returns, it's essential to keep in mind that the IRS has the authority to audit any tax return, including those involving 1031 exchanges. However, due to limited resources, the IRS tends to concentrate its efforts on returns that show potential for substantial gains, from the IRS's perspective.

In practice, less than 0.4% of tax returns are audited, indicating that the vast majority of taxpayers can breathe a sigh of relief. Of those that are audited, approximately 85% are subject to simple requests for extra documentation generated by computers. These requests can typically be addressed by mailing the requested information to the IRS and require minimal effort on the taxpayer's part.

It's important to note that while the odds of being audited are relatively low, they are not zero. Furthermore, the 2022 Inflation Reduction Act provided funding for increased enforcement efforts by the IRS, which may lead to more audits in the future.

Therefore, it's always a good idea to ensure that your tax return is accurate and complete and to retain any documentation related to your 1031 exchange for at least three years after the exchange. This way, if the IRS does decide to audit your return, you will have the necessary paperwork to support your claims.

Wealthy taxpayers have a low audit probability (1%), while low-income taxpayers claiming the earned income tax credit are at a higher risk (13%). Taxpayers with high business or farm income (over $200,000) have a slightly lower audit chance than low-income taxpayers. However, the following actions can trigger an audit:

●     Failing to report all income

●     Making math errors

●     Claiming higher than average deductions or losses

●     Claiming higher than expected charitable deductions compared to income

●     Operating a business

●     Claiming business losses for hobby expenses

●     Claiming large rental losses

●     Incorrectly reporting the Health Premium Tax Credit

●     Taking an early withdrawal from a 401(k) or IRA

●     Conducting digital asset and virtual currency transactions

●     Underreporting gambling wins or overreporting gambling losses

●     Claiming a research and development credit.

Red Flag Issues

The IRS may identify red flag issues with some 1031 exchanges, which allow taxpayers to reinvest the proceeds from selling real estate in "like-kind" property and defer the recognition and payment of capital gains from the sale. For instance, if a taxpayer sells an office building for $800,000, which they purchased for $500,000 three years ago, they could potentially have a capital gain of $300,000. By using a 1031 exchange, the taxpayer can defer taxes due on that gain and delay a depreciation recapture payment.

Successfully completing a 1031 exchange can be challenging, and taxpayers must carefully follow the IRS rules to avoid disqualification of the exchange attempt. Some of the provisions that can pose difficulties include:

●     Tight timelines: The investor must complete the exchange within 180 calendar days of selling the original property, with a 45-day window to identify potential replacement properties. To comply, the taxpayer must notify the Qualified Intermediary of the possible replacements, following specific rules.

●     Three properties rule: The taxpayer can identify up to three potential acquisitions with no limit on the individual or aggregate value.

●     200 percent rule: The taxpayer can identify any number of potential replacements, but the combined value of all properties cannot exceed 200 percent of the value of the relinquished asset.

●     95 percent rule: The taxpayer can identify any number of properties with any individual or combined value but must acquire 95 percent of the total identified property value before the deadline.

The 1031 exchange process involves several challenging provisions, and taxpayers must carefully follow IRS rules to succeed. Here are some of the key considerations:

Engaging a Qualified Intermediary: Taxpayers must use a Qualified Intermediary to receive the potential replacement properties and safeguard the proceeds until the replacement property's acquisition. The Qualified Intermediary must maintain a separate account for the funds and can't be related to the taxpayer, a close business associate, or an agent.

Like-kind exchange: The IRS allows almost any exchange of investment and business property as long as the properties are "like-kind." However, taxpayers may not exchange a personal residence and must hold the property for two years before trading it. Flipped properties are also ineligible for the exchange.

Matching value and debt level: The replacement property must have the same or greater market value as the relinquished asset, and if the original property is encumbered, the replacements must carry an equal debt level.

To maximize potential tax relief, taxpayers should consider including the 1031 exchange in their tax planning. However, like other activities that could trigger an audit, it's essential to keep meticulous records to support any deductions, credits, or deferrals claimed on tax returns.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

• There’s no guarantee any strategy will be successful or achieve investment objectives;
• All real estate investments have the potential to lose value during the life of the investments;
• The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
• All financed real estate investments have potential for foreclosure;
• These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
• If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
• Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits