The letters are addressed to “Client X,” who scanned and emailed them to you at midnight over a holiday weekend. You forgot to turn off email notifications after a night of celebrations, and the alert rings, belting out the Minnie Ripperton tune “Lovin’ You,” on your phone.
Your stomach tightens as you glance at the attachments and the client’s plea for help, typed in all red caps. Suddenly awake, you realize the email is from a client that serially exchanges its real property assets. The letters were from the IRS and the state tax board. You remember that this client engaged you years after the stated audit years in the letters. You splash cold water on your face, hoping it’s all a bad dream, but it’s not. The email is still there in your inbox the next morning. You curse the politicians who drafted and passed The Tax Cut and Jobs Act of 2017 legislation, as it relates to changes in the tax code for like-kind exchanges, wishing at that moment that real estate interests had also fallen victim to that legislation.
If you can identify with this situation, think about implementing some organization and management strategies going forward with clients who want to engage in like-kind exchanges, at least until Congress decides one day in the future to wipe out those tax deferral provisions entirely from the Internal Revenue Code. (To simplify the discussion, this article will only address issues as they relate to forward exchanges.)
What happened? The next day you call Client X and the client’s counsel to discuss a strategy for dealing with the audits, as well as how future exchanges can be documented and monitored. It’s a moribund task, but both of you try to unpack what happened with Client X’s exchanges for those tax years. Were there structural failures where the technical requirements of Section 1031 of the code were not met? Was the intermediary qualified under Treasury Regulation Section 1.1031(k)-1(g)(4)? Did Client X engage in an exchange or exchanges that would be classified as a partnership transaction, and was it ambiguous as to who the actual taxpayer was in the exchange?
As you delve into the possibilities and discuss with Client X and his counsel, it’s clear they were unaware of the possible pitfalls. You reach for pain relievers for a headache, since you were not involved in documenting the exchanges. Forensic-like, you start to figure out with Client X and his counsel if the exchanges qualified under the federal and state laws and guidelines.
Get organized
To decode the transaction, you ask Client X whether or not an exchange transaction checklist and spreadsheet have been prepared. The silence that follows your question gives you the answer. You explain that an exchange transaction checklist and accompanying spreadsheets act as a roadmap for the exchange or series of exchanges (i.e., when there are split exchanges). Why rely on your memory to track the steps of an exchange transaction when you have many other clients and federal and state audits could be years off into the future?
As in any transaction, checklists keep track of critical transaction dates, the parties involved in the transaction, the various tasks, allocation of responsibilities for those tasks to the parties involved, and the transaction documents. The checklist should also track other issues, such as whether or not consent is required under the terms of the relevant corporate documentation if the taxpayer is an entity. Always anticipate an audit, and prepare a closing binder, either hard copy or electronically, containing all of the relevant purchase and exchange documentation. The binder should be indexed so an auditor can easily find the various documents, particularly those related to the exchange documentation.
For a forward exchange, the relevant documents would include the following: an exchange agreement, a trust agreement (if applicable), an assignment of relinquished property purchase contract and notice of assignment, a relinquished property closing settlement statement, a 45-day identification letter, assignment of replacement property purchase contract and notice of assignment, a replacement property closing settlement statement, and the intermediary’s statement of account tracking exchange balance funds.
The exchange spreadsheet is vital to tracking the history of the exchange and is prepared by the accountant. It should track the basis of the property, adjustments to the basis, identify all properties involved in the exchange together with the sale price of the relinquished property and the purchase price of the replacement property, confirm whether the exchange would comply with the identification rules (e.g., 200% identification rule if applicable, three-property rule, 95% rule, etc.), note any identified “boot” issues (explained below), and specify percentage interest calculations if the properties involved are part of other split exchanges.
Get your team together. Any exchange transaction should involve the client’s professional team, consisting of counsel, accountants and principals. Many exchanges go awry because there is no team to act as a check and balance on the various aspects of the transaction and to raise issues at the outset and during the exchange that could affect the viability of the exchange or exchanges.
Did the client satisfy the technical rules of a 1031?
Your client is more likely than not going to be subject to an audit if it has failed to satisfy the technical rules for a 1031 like-kind exchange. As a threshold matter, the properties involved in the exchange must meet the requirements of a “like kind” real property interest under the TCJA. The property must be held and used in a productive trade or business or as an investment for certain time periods, and the critical exchange transaction dates, the 45-day identification period and the 180-exchange period must be closely adhered to.
To avoid “boot” issues, the replacement property must be of equal or higher value than the relinquished property and all relinquished property exchange proceeds must be reinvested into the replacement property. Lastly, the client must report any “boot.” In the case of Client X, you learn that what may have triggered the audits was the fact that the client had not unambiguously identified the replacement property. Client X had intended to acquire a fractional interest in a replacement property but did not identify that interest. Since the subject exchange was an improvement exchange, Client X also did not specifically identify the improvements that were intended to be made to the real property.
You then discover that Client X has another audit problem and has made an exchange of partnership interests in an entity, which is specifically prohibited by Section 1031(a)(2)(D), regardless of whether the interests exchanged are general or limited partnership interests. Both the state and federal auditors examined the purchase contracts for the exchanged properties, the entity documentation, and the assignment provisions in the purchase contracts. Additionally, the auditors noted that there were anomalies in the source of the funds used by Client X’s exchanging entity to facilitate the exchange. As Client X learned, deferred gain from California relinquished property must be sourced to California, regardless of where the replacement property is located.
This issue could have been resolved in any of three ways, and each one of these methods could be the subject of separate articles: distribute an undivided interest in the partnership, a “cash out” of certain partners who do not want to exchange into other real property interest; liquidate the partnership and transfer the real property to tenancy in common interests (subject to being able to satisfy the “held for productive use in trade or business or for investment purposes” requirements); “drop and swap” (distribution of the real property interests to the partners prior to the exchange) or “swap and drop” (distribution of the real property interests to the partners after the exchange). Client X did not avail himself to any of these options, and failure to do so under federal and tax requirements could subject him to civil and/or criminal penalties.
Who can be a qualified intermediary?
Client X’s problems with the exchange are not over yet. The IRS has questioned the validity of the intermediary Client X used. A qualified intermediary is defined under the Treasury regulations as a person who is not the taxpayer or a disqualified person, who enters into a written agreement (the “exchange agreement”) with the taxpayer to acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. A qualified intermediary is defined under the regulations as any person who is not the taxpayer or a disqualified person. Disqualified persons include any party that had a financial relationship and acted on the taxpayer’s behalf in dealing with a third party during the previous two years, as well as a related party.
After the losses suffered by taxpayers during the Great Recession, some states passed legislation that set restrictions and licensure standards for insurance and escrow or trust account ownership. Here, the independence principle is paramount, and it becomes apparent that Client X did not follow the regulations but instead selected his brother-in-law, who is also his business partner, to act as a qualified intermediary.
You advise Client X and his counsel on the best practices going forward to avoid future audits (or pass them with flying colors), somberly close your briefcase, and gear up for the audits ahead.
