Taxpayers aren't exactly adhering to the Boy Scout honor code when they use 1031
exchanges to defer capital gains taxes, government watchdogs say. So expect more
spot checks and audits by the
Internal Revenue Service if you're using the
popular technique to defer capital gains taxes on land or other business
property.
Last September the IRS agreed to step up oversight of like-kind exchanges after
a report by the Government Accountability Office criticized the agency's
handling of the issue.
In a report acquired by DTN, Kathy Petronchak, an IRS commissioner, said the
agency would take corrective actions, including conducting a study of compliance
and revising taxpayer instructions for 1031 property.
A COMMON BUT COMPLEX TOOL. Until recently, more than half the farmland that
traded hands in Illinois and up to a third of farmland in other Midwest states
involved like-kind exchanges.
Owners frequently swapped land in the path of development for property in less
congested and more affordable areas.
While such property generally qualifies for tax-deferment, amateurs also were
relying on misinformation from realtors or unscrupulous agents to conduct
transactions on unqualified properties—such as vacation homes—or to misrepresent
their tax basis, the IRS said in the report from the Treasury Inspector General
for Tax Administration.
Even honest taxpayers may be snagged by the complexities of 1031 provisions, tax
practitioners add.
With Midwest farmland appreciating at double-digit rates the past few years,
"the risks of [messing] up and triggering a gain on a land sale could be
outrageous," says Rick Christiansen, a CPA who oversees agribusiness accounts
for LarsenAllen LLC in New Ulm, Minn.
If the IRS finds taxpayers have not followed the rules, they can be held liable
for taxes, penalties and interest on their transactions.
Christiansen says it's imperative taxpayers meet terms for eligible property,
comply with the law's deadlines for identifying the substitute property and
closing the transaction. Taxpayers also should use what IRS calls qualified
intermediaries to handle details and escrow accounts.
"That means that you can't use your own attorney to handle the funds, and that
you never touch the proceeds yourself," Christiansen adds.
POPULARITY SOARS. Under 1031 exchanges, taxpayers can defer all capital gains on
business or investment property if they buy like-kind replacement property at
the time of sale.
Tax liability may be forgiven upon the death of the investor because heirs may
qualify for stepped-up tax basis on the inherited property. Between 1998 and
2004—the latest tax year studied—the dollar amounts deferred by 1031s jumped
from $22.8 billion to $73.6 billion.
While controversial in farm country, several attempts to have Congress tighten
use of 1031 exchanges so far have been defeated as part of the farm bill debate
and related tax provisions. For a copy of the recent IRS report, go to
www.ustreas.gov/tigta/auditreports/2007reports/200730172fr.pdf.