If you're alarmed by newspaper headlines announcing that the Internal Revenue Service plans to tighten the rules on 1031 tax-deferred exchanges and audit more taxpayers, take a deep breath. That may happen, but it's far from a certainty.

The heightened discussion of “like-kind” exchanges — also called 1031 or Starker exchanges — stems from the release of a September 2007 report by the Treasury Inspector General for Tax Administration (TIGTA). The report found that in 2004, taxpayers filed about 338,500 IRS forms claiming deferred gains or losses of more than $73.6 billion. That was double the number of like-kind exchanges reported six years earlier and triple the total dollar amount deferred.

The report also found that taxpayers may be improperly claiming exchanges for vacation or second homes and that some exchange promoters may be misleading taxpayers into believing such exchanges are proper. “There appears to be little IRS oversight of the capital gains (or losses) deferred through like-kind exchanges,” the report concluded.

Revisions a possibility

Though some news reports state that the Treasury Inspector General found that taxpayers have been improperly taking advantage of exchange rules because of inadequate IRS oversight, the report's findings were much less conclusive.

“This audit was initiated to evaluate the IRS' oversight of the deferment of capital gains tax through like-kind exchanges,” says Kathy McFadden, senior auditor at the Treasury Inspector General's office. “TIGTA also determined whether taxpayers' use of this investment strategy is growing and whether this poses any specific problems for the IRS.”

In other words, the Treasury Inspector General's report was intended only to evaluate the risk to the IRS and taxpayers of the improper use of exchanges. Taxpayers may be abusing like-kind exchanges — and depriving the IRS of revenue — or unknowingly paying too much in tax because of unclear guidance by the IRS.

“We're not saying we saw those problems,” says McFadden. “But with the increase in the number of forms being filed for like-kind exchanges, if the IRS is going to take a closer look at the program, does it have the resources?”

The IRS has adopted the report's recommendations. Specifically, it has agreed to study reporting and compliance issues associated with like-kind exchanges. It will also revise instructions for certain tax forms, update its Web site, and provide additional guidance on like-kind exchanges to taxpayers and practitioners.

More audits to come?

Whether this focus on exchanges will lead to more audits is pure speculation. The IRS declined to comment for this column. William Exeter, president and CEO of Exeter 1031 Exchange Services in San Diego doesn't think the IRS will increase audits. “The report criticizes the IRS for not having adequate oversight, so the IRS will evaluate its policies and procedures. The interpretation is that will more than likely result in more audits, but that's not necessarily a foregone conclusion.”

Exeter isn't greatly concerned. “It essentially confirms the position we've taken all along, that the IRS doesn't have adequate supervision of 1031 exchanges. Also, it's not clear what the taxpayer's duty is, what properties qualify, and how to report a 1031 exchange.”

Jim Brondino, president of Brondino & Associates in Ontario, Calif., who specializes in tax-deferred exchanges, says misunderstandings surrounding like-kind exchange rules extend not only to taxpayers. Accountants, for example, often don't know that exchange deadlines are absolute. “They may not have met deadlines and may file the transaction as a 1031 anyway,” says Brondino.

Despite the confusion, it would be a mistake for the IRS to tighten the screws on exchanges in a way that significantly reduces the number of exchanges that take place, says Brondino. “That would be the IRS shooting itself in the foot.”

Much like the sale of a home creates a cascade of revenue for related businesses, such as home improvement stores, the sale of commercial properties has the same effect. The transactions create taxable income for the IRS. “The momentum created by exchanges gives the IRS more revenue than it would get if it eliminated the exchange and taxed transfers. There would be a substantial reduction in transactions in play if the IRS eliminated the 1031,” says Brondino.

Even if the IRS doesn't put a stranglehold on 1031 exchanges, might Congress pass legislation tightening the rules as a way to generate revenue? That's unlikely during 2008, says Linda Goold, a tax lawyer with the National Association of Realtors, who closely follows Congressional initiatives on exchanges. “Beyond 2008,” she says, “it's too early to say.”

G.M. Filisko is a reporter and attorney based in Chicago who writes regularly on legal and real estate issues. She can be contacted at gabifil@rcn.com.

SWAPPING PROPERTIES IS BIG BUSINESS

The number of 1031 tax-deferred exchanges entered into by real estate owners has grown dramatically since 1998.
1998 2004
Tax-deferred exchange forms filed with IRS 164,956 338,500
Total losses or gains deferred $22.8 billion $73.6 billion
Source: U.S. Treasury Inspector General for Tax Administration