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1031 like-kind exchanges are a tax provision dictated by section 1031 of the Internal Revenue Code. They are used to defer taxes on capital gains resulting from a sale of real property, and therefore are an option for taxpayers who want to reinvest their funds into a different property.

Although 1031 exchanges are mostly straightforward, there are rules and deadlines to observe during the process. Failing to observe these rules may result in an expensive tax bill (and penalties). So, before engaging in a 1031 exchange, it is recommended that investors consult with a knowledgeable tax attorney first.

How a 1031 Like-Kind Exchange Works – a Small Business Example

1031 exchanges are generally reserved for investment purposes – a rule cemented by the 2017 Tax Cuts and Jobs Act (TCJA). Prior to the TCJA, tax paying entities could swap out some types of personal property (such as equipment), but 1031 exchanges are now confined to real estate property exchanges only.

For example, a small business owner – let’s say an auto dealership owner – decides that his current location is no longer suitable for his current needs, or perhaps the value of his current property has skyrocketed. Being a savvy investor, he starts looking for another location that might serve his auto dealership better and prepares to sell his current property. After a brief search, he finds an excellent location in a nearby suburb.

Economically, it’s better for everyone – the business owner, the real estate companies, the local community and the IRS – for this transaction to go ahead. It drives additional economic activity and produces additional tax revenue. However, by selling his current property, the auto dealership owner must pay capital gains taxes from the  proceeds of the sale.

To prevent taxes from blocking important economic activity, the IRS allows investors to switch out one like-kind property for another and defer capital gains taxes in the process. This is the tax-led philosophy behind allowing 1031 like-kind exchanges.

In this example, the auto dealership owner opts for a 1031 exchange to essentially move his business to a better location, using the funds generated from the initial property’s sale to acquire the new property. Any capital gains taxes generated from the sale are deferred, perhaps indefinitely.

This is a general overview of 1031 exchanges. In practice, there are several moving parts during the 1031 exchange process that taxpayers must manage to successfully see the process through.

The 1031 Like-Kind Exchange Process

If you and your tax attorney agree that a 1031 exchange makes sense for your current tax needs, here is what the process typically looks like:

• Determine which properties to exchange – First, you’ll need a pair of real properties to exchange. They must be “like-kind,” though the IRS’s definition in this area is broad. As long as both properties are investment properties, a 1031 is acceptable in most cases. Taxpayers can exchange an apartment complex for an industrial center, for example.
• Identify an intermediary (middleman) to facilitate the transaction – 1031 exchanges are automatically invalidated if the taxpayer accesses the proceeds from the sale at any point. Once the initial property is sold, the proceeds must be given to an intermediary that holds the funds in escrow. Those funds are used to facilitate the purchase of a new property. There are dedicated exchange facilitators who can serve in this role for investors.
• Make the exchange – From the date that the initial property is sold, you have 45 days to identify up to three potential exchange properties. These must be identified in writing and given to the intermediary. There’s a second deadline. From the date of sale, you have 180 days to purchase the new property.
• Notify the IRS of the 1031 exchange – Once the 1031 exchange is complete, the buyer must report the transaction to the IRS, using Form 8824. The buyer will need to provide details of the transaction, including the properties, parties and dates involved. They will also need to report the adjusted tax basis of the sold property.

Important 1031 Like-Kind Exchange Considerations

Like with most tax provisions, there are rules dictating how 1031 exchanges may be utilized. There are also additional considerations that may guide a taxpayer’s decision. For example:

• A 1031 exchange can be done in reverse – Investors may identify and purchase the new property first before selling their current property. Termed a “reverse exchange,” a titleholder may be necessary to facilitate this transaction.
• Capital gains taxes are deferred, not eliminated – 1031 exchanges may delay capital taxes, but the bill comes due if the new property is ever sold without another 1031. However, if the property owner dies before the property is sold, the capital gains taxes are wiped out. As such, 1031 exchanges are a popular estate planning tool.
• There can be no conflict of interest along the way – The intermediary must not be personally or professionally connected to any party involved in the 1031 exchange. That includes family members, business partners, employees, or anyone who provides professional services to the investor (an attorney, accountant, banker, agent, etc.). Anyone who has served the investor in the previous two years in one of these capacities is also disqualified.
• Sometimes, it makes sense to just pay the tax – While 1031 exchanges can reduce tax liabilities, it may not be worth the time and money to execute one. It takes considerable organization and time, as well as multiple parties to see the process through. For some transactions, the math may not make sense. A trusted tax attorney can ascertain whether that’s the case or not.

A Reputable Tax Professional Can Help with a 1031 Like-Kind Exchange 

By tax provision standards, 1031 like-kind exchanges are straightforward and simple to report. However, they are not always straightforward to organize and execute. Deadlines can be tight, and there will be additional complexities if there are liabilities tied to the property.

A tax attorney or accountant (or better yet, both) can adjust for these factors and ensure their client stays on time. In fact, a tax attorney can help their clients 1031 exchange their property for an intermediary property that’s only held for a short time to facilitate a second exchange. These are advanced tax maneuvers that require a tax professional to manage properly.

If you’re interested in exploring 1031 exchanges, our team of CPAs and tax attorneys can assess your situation and determine whether a 1031 will provide a tax advantage.

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For those who have never experienced an IRS audit, your only exposure to the process may be the brief portrayal in TV shows and movies where someone, or a team of people, wearing bland neutral suits shows up at your workplace and declares, “You’re being audited. Show us your books.” The reality of real-life audits is a bit different. If you’re being audited by the IRS, your first notification will likely come through the mail. The dreaded tax letter will be sent to the address on file with the agency, which means if you’ve moved without informing the government, it could be sent to a previous address. Whether it’s sent to the right address or not, the IRS will proceed with the audit, assessment, and collection process.

If you have received a tax letter from the IRS, a tax attorney can provide representation to the agency and guidance to their client on how to proceed.

You’ve Received Notice, but is it an Assessment or a Full-scale Audit?

 Increasingly, the IRS is sending out letters notifying taxpayers of an assessment rather than a full-scale audit. These assessments tend to be income adjustments that the IRS makes on their end due to information they’ve received from reporting agencies. In the letter, the IRS will explain the amount of taxes they believe is correct, with a possible explanation as to why, and then there will be an explanation of your rights to protest this change and the procedure to follow. When a taxpayer receives an assessment letter, they may respond and take steps to protest or appeal the decision. Otherwise, if the taxpayer does not respond, the IRS will move forward with collection. If the taxpayer has underpaid, notices that follow will inform the taxpayer how much is owed.

If the IRS has determined a full audit is necessary, the agency will notify the taxpayer that an audit is underway and that an assessment may be forthcoming. In the past, the IRS would often show up at the taxpayer’s place of residence or business to acquire documentation. Since the COVID pandemic, this part of the process is now largely done online and via telephone.

 Audit, Assessment, Collections: The Three-stage Notification Process

 It generally takes several months to complete an audit, and the taxpayer will be notified by mail throughout the process. Typically, the IRS will communicate with the taxpayer through the audit, assessment, and collection process, and typically looks like the following:

• Audit – The first piece of mail from the IRS will either be notification of an audit or of an assessment. If it’s an audit, the letter will notify the taxpayer that their tax situation is being reviewed. Requests for financial documentation will likely be forthcoming.
• Assessment – Once the audit is underway, or after it’s complete, the IRS will send a letter with an assessment in it. This assessment is the IRS’s official stance on the taxpayer’s position, specifying whether income or deductions are to be adjusted, and whether this will require the taxpayer to remit additional taxes. Following an assessment, the taxpayer will have a brief window where they may contest the IRS’s conclusions.
• Collections – If an assessment is made and moved forward, the taxpayer will receive a collections letter requesting payment.

A tax attorney can provide assistance at any point during this communication. For example, an attorney can help with acquiring or interpreting financial documentation. They can also push back against the IRS’s assessment, arguing on behalf of their taxpayer client and attempting to have the assessment thrown out.

 How Does the IRS Determine Who to Audit? 

The IRS audits one out of every 500-1,000 tax returns a year, and it uses a handful of strategies to determine who to audit, including:

• Random selection – A large part of the IRS’s selection criteria is purely random, in part to assist the department in keeping their statistics current (i.e. what percentage of taxpayer returns are accurate without IRS intervention).
• Income and certain credits – Higher income taxpayers are more likely to be flagged for an audit, as well as those who report under $25,000 in income annually. Further, taxpayers who take large deductions or tax credits (the Earned Income Tax Credit, for example) are more likely to be flagged.
• Algorithmic analysis – The IRS also uses predictive algorithms to determine which taxpayers to audit.

Although audits are relatively rare, they are still a source of stress for many Americans waiting to see if they are up for an audit this year.

How Long do Taxpayers Have to Wait Until They Know if They Will be Audited?

 In general, the IRS will audit a tax return within three years of submission to the agency. That’s a long time, but the vast majority of returns are audited within 18 months, if they are to be audited at all.

However, there is no statute of limitations on fraud or tax evasion audits, so if either is the trigger behind an audit, it may occur at any point.

 An Experienced Tax Attorney Can Provide Expert Representation During an Audit

 An IRS audit may greatly alter an individual’s or business’s tax outlook well into the future. It may also come with additional penalties and fines that will further increase the stakes.

As a taxpayer, you have the right to seek professional representation, and it is highly recommended. Tax accountants and attorneys are both qualified to provide this representation, which includes communicating with the IRS, making formal arguments to the agency regarding their client’s tax position, and essentially making the case to the IRS on their behalf.

The IRS is a powerful organization that is best interfaced with through a knowledgeable tax professional. By partnering with an experienced tax attorney, you’ll have expert guidance throughout the auditing process and put yourself in the best possible position to navigate an IRS audit.