IRS To Tackle Abuse Of Second Home '1031' Exchanges

by Mike Godfrey, Tax-News.com, Washington

10 October 2007

'Like-kind' exchanges, also known as 'roll-over' transactions or '1031' exchanges, which allow taxpayers to defer capital gains tax on real estate held for business purposes if it is sold and then replaced with another property within a specified period, are coming under increased IRS scrutiny.

The IRS is responding to a report from the Treasury Inspector General for Tax Administration issued last month which says there is need to tighten up supervision of such exchanges, which have ballooned in volume over the last few years, totaling US$75bn of tax deferred in 2004. Given the increase in real estate values since then, it could be expected that the value of tax deferred is now well over US$100bn and could be much higher.

The Report stated that there is little IRS oversight of §1031, that the IRS is relying on taxpayers to voluntarily comply, and this has resulted in underreporting of gain. The report particularly mentioned vacation or second home exchanges. Under the rules, a vacation home used exclusively by the owner or related parties may not be
exchanged (because there is no business purpose). The situation is unclear when there is mixed private and commercial rental use. The Report suggests that many promoters of 1031 exchanges are misrepresenting the law to their clients, and that many exchanges would be found to fall outside the terms of 1031 if they were examined closely.

The IRS says it will take the following action:

• The IRS will conduct a study of reporting and compliance issues associated with like-kind exchanges based on returns selected by the National Research Program (a comprehensive effort by the IRS to measure payment, filing and reporting compliance). From the study, the IRS will recommend audit target areas for §1031.
• The IRS will revise its guidance on the filing of Form 8824 to provide that a taxpayer must file Form 8824 if the taxpayer completed an exchange.
• The IRS will provide additional guidance regarding exchanges of second and vacation homes that were not used exclusively by the owners.

The report said IRS staff have reported probable abuses, such as transactions involving inappropriate properties, or exchanges with related parties, or incorrect property basis figures.

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