We are often asked how Section 1031 transactions are monitored by the Internal Revenue Service (IRS) and whether a 1031 police force exists to monitor taxpayer actions. The truth is that in nearly three decades of practice, we have never been informed of the existence of this authority. However, we regularly point out to clients that each action they take with respect to their investment property is documented in their own books and records and collectively comprise a written audit trail for the IRS to follow in the event of an audit. Additionally, tax returns are signed by the taxpayer “under penalties of perjury.” The general perjury statute under Federal law defines perjury as a felony and provides for fines and/or a prison sentence of up to five years.
For example, a client purchases a seasonal rental property with the proceeds of a Section 1031 sale of a three family investment/rental property. The client is counseled on personal use of the new or Replacement Property and subsequently, over the next several months, he is careful to document that his own personal use of the property is limited to no more than 14 calendar days or 10% of the days actually rented; whichever is greater. Summer blooms and the client’s family is anxious to use the property for the month of July. He is fully aware of the personal use limitations but chooses to ignore them and the family goes on holiday without a care in the world; after all, he rationalizes that there are no 1031 Police.
Two years later, an envelope arrives in the mail informing the client that his past three years tax returns will be audited based on unusual business expenses. When tax returns are filed, the IRS computers assign a “differential” score based on the Discriminate Information Function (DIF) system. The higher the DIF score, the higher the likelihood for an audit. While the formula is a highly guarded secret, the chances of a higher DIF score goes up with your income and the biggest red flag is high deductions compared to your income. Occupation and zip code also contribute to the final score. The mere fact that a Form #8824 (Like-Kind Exchanges) is filed in the tax year of the sale of the Relinquished Property does not affect the DIF score, so exchanges are neutral with respect to audit risk.
At the commencement of the audit, the client doesn’t give another thought to the seasonal rental property. The IRS seems centered on the business expenses. However, the entire file is now subject to IRS agent’s scrutiny. Since the seasonal property income fluctuates from year to year, the agent decides to look a little closer at the reason for the variances. It seems unusual that at the height of the summer season, there isn’t any rental of the property. He asks for the records of the leasing agent and discovers that the property was listed as “Not Available” for rental during the month of July in the past three years. Oops, now the tax deferred status of the seasonal rental property is totally in jeopardy. This could negate the Section 1031 tax deferral treatment and additionally subject the taxpayer to fees, fines and penalties.
The chances of finding an agent with a tendency for leniency is about one in ten thousand (or higher). There is a new initiative to increase the number of IRS agents by 3,000 and tax examiners by 4,600 over the next year to replace retiring staff and to go after tax shelter abusers. You can expect these new agents to be looking for recognition from their supervisors. In short, don’t expect any special favors, play by the rules and as your mother always told you “mind your p’s and q’s.”