by Maura Snabes, Esq., CES, NTP

The acronym “IRS” often stirs anxiety among taxpayers—and understandably so. When it comes to a 1031 exchange, many wonder what role the IRS plays, what it scrutinizes, and what actions might trigger an audit.

IRS Oversight of 1031 Exchanges

The IRS is tasked with monitoring and enforcing compliance with the rules and regulations governing 1031 exchanges. These transactions allow for the deferral of capital gains taxes when investment or business properties are exchanged for like-kind properties. Because this deferral is a significant tax benefit, the IRS audits such exchanges to ensure taxpayers are accurately reporting their exchanges and strictly following the guidelines set forth by the IRS.

How Likely Is an Audit?

Any tax return is potentially subject to an IRS audit, though the overall risk is relatively low:

• Fewer than 0.4% of tax returns are audited annually.
• About 85% of these are basic, computer-generated requests for documentation.
• High-income taxpayers and those with complex transactions face slightly higher audit rates.
• The 2022 Inflation Reduction Act allocated increased funding for IRS enforcement, suggesting audit rates may rise in future years.

Key Audit Statistics:

• Wealthy taxpayers (millionaires) face about a 1% chance of being audited.
• Low-income taxpayers claiming the Earned Income Tax Credit (EITC) have a 13% audit risk.
• Taxpayers with over $200,000 in business or farm income may be scrutinized slightly more than average but less than EITC claimants.

What Triggers an Audit in a 1031 Exchange?

Several factors may raise red flags to the IRS, including:

• High-value or unusual transactions
• Use of non-compliant strategies, such as related-party exchanges intended to sidestep tax liability
• Errors or inconsistencies in the exchange documentation
• Failure to report all income
• Mathematical errors
• Large or atypical deductions
• Disproportionate charitable contributions

What the IRS Reviews During a 1031 Exchange Audit

During an audit, the IRS will scrutinize the exchange documents, financial records, and supporting documentation, along with the following elements of the transaction:

1. Like-Kind Requirement

• Both relinquished and replacement properties must be held for investment or business use.

2. Strict Timelines

• 45-day identification period to name replacement properties.
• 180-day acquisition period to acquire the new property. For reverse exchanges, conveyance of relinquished property and conveyance of replacement property/assignment of membership interest of EAT entity.

3. Qualified Intermediary (QI)

• A QI must handle the transaction; relatives or agents of the taxpayer are disqualified.
• The QI holds exchange funds and ensures regulatory compliance.

4. Handling of Funds

• All proceeds from the sale of the relinquished property must be reinvested.
• If the taxpayer receives any non-like-kind property (known as “boot”), it becomes taxable.

5. Property Identification Rules

• The taxpayer must comply with one of the following:
  • Three-property rule
  • 200% rule
  • 95% rule

6. Ownership Consistency

• The entity or individual that sold the relinquished property must also acquire the replacement property, meeting the “same taxpayer” requirement.

7. Proper Reporting

• The transaction must be accurately reported on IRS Form 8824.

Consequences of Non-Compliance

If an exchange fails to meet IRS requirements, the taxpayer:

• Loses the tax deferral benefit.
• Becomes liable for capital gains taxes and possibly depreciation recapture.
• May incur penalties and interest.

Best Practices to Minimize Audit Risk

To protect the integrity of a 1031 exchange and reduce audit exposure:

• Work with a Qualified Intermediary (QI).
• Engage tax and legal professionals.
• Strictly adhere to all timelines and reporting requirements.
• Maintain thorough documentation, including:
  • Identification notices
  • Closing statements
  • Communications with QIs and third parties

Conclusion

The IRS plays a critical role in ensuring 1031 exchanges are legitimate and compliant. While the audit risk remains low for most, those engaging in high-value or complex transactions should exercise caution. Proper planning, professional guidance, and meticulous documentation are key to successfully navigating IRS scrutiny and maintaining the tax-deferral benefits of a 1031 exchange.