Audit Proof Your Section 1031 Exchange

Taxpayers contemplating using the provisions of Internal Revenue Code Section 1031 are well advised to audit proof their transactions. The mere fact of including Form #8824 as part of the supplemental schedules in a taxpayers tax return will not give rise to the return being pulled for audit by the Internal Revenue Service (IRS). The Form #8824 simply documents that the sale of commercial/investment real property and it’s like-kind replacement property was conducted in a timely manner as a Section 1031 Exchange.

The IRS uses a ranking system to determine the tax returns that it will review for audit on an annual basis.  The ranking system is commonly referred to as the DIF score or Discriminate Information Function system. It is a closely guarded formula that begins with the industry or business code associated with the taxpayer.  Each line of the return is assigned a number and then compared with a peer group.  The higher the score, the higher the likelihood that the return will be subject to audit. Some audits are pulled randomly and some based on zip codes so the score is only part of the story. Section 1031 Exchanges are neutral when it comes to audit risk.

The fear of an audit should not deter a taxpayer from using every legitimate deduction available under the Internal Revenue Code.  Section 1031, a part of the  Code since 1921,  is well tested and proven to work for every taxpaying entity and/or individual. More than 85 years of case law exist to define the edges of the protection afforded in tax deferred exchanges.  It is necessary, however, to follow the guidance and document actions to support that the Relinquished or old property qualifies for 1031 treatment as well as the new or Replacement Property.  Taxpayers who try to expand the safety zone have often found themselves in tax court arguing in vain.

A case in point.  A taxpayer owns a second home which he believes will qualify for 1031 treatment based on the literal interruption that the property is held for “investment.” However, it is not possible to extract the benefits of 1031 for personal use property. If the property has been used for more than personal use limits of 14 calendar days or 10% of the days actually rented, the taxpayer will have one of two choices to make.  First, move into the property and make it the primary residence for two of the next five years with an eye toward a prorated Section 121 exclusion at sale. Secondly, cease personal use beyond the limitations and rent the property to others (unrelated to the taxpayer)  for more than 14 calendar days in each of the next two years.

Documentation is key; each action is recorded in an unwritten “audit trail.” For example, if the taxpayer votes in Florida, registers a vehicle there and files the tax return from the sunny south, then he cannot claim Massachusetts as his primary residence.  Only one property at a time can qualify as the principal residence. The story must be consistent for the two years preceding the sale and for two years after the purchase of investment property.

It is permissible to change the use of your property from investment/rental to personal or back again during your ownership. You must be consistent in your reporting of these events and document your usage to comply with the allowed limitations. Don’t be food for IRS fodder.

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