The letters are addressed to “Consumer X,” who scanned and emailed them to you at midnight over a vacation weekend. You forgot to show off e-mail notifications after an evening of celebrations, and the alert rings, belting out the Minnie Ripperton tune “Lovin’ You,” in your telephone.
Your abdomen tightens as you look on the attachments and the consumer’s plea for assist, typed in all purple caps. Abruptly awake, you understand the e-mail is from a consumer that serially exchanges its actual property property. The letters have been from the IRS and the state tax board. You keep in mind that this consumer engaged you years after the acknowledged audit years within the letters. You splash chilly water in your face, hoping it’s all a nasty dream, however it’s not. The e-mail remains to be there in your inbox the subsequent morning. You curse the politicians who drafted and handed The Tax Minimize and Jobs Act of 2017 laws, because it pertains to adjustments within the tax code for like-kind exchanges, wishing at that second that actual property pursuits had additionally fallen sufferer to that laws.
When you can determine with this case, take into consideration implementing some group and administration methods going ahead with purchasers who wish to interact in like-kind exchanges, at the least till Congress decides sooner or later sooner or later to wipe out these tax deferral provisions solely from the Inside Income Code. (To simplify the dialogue, this text will solely tackle points as they relate to ahead exchanges.)
What occurred? The subsequent day you name Consumer X and the consumer’s counsel to debate a method for coping with the audits, in addition to how future exchanges may be documented and monitored. It’s a moribund activity, however each of you attempt to unpack what occurred with Consumer X’s exchanges for these tax years. Have been there structural failures the place the technical necessities of Part 1031 of the code weren’t met? Was the middleman certified beneath Treasury Regulation Part 1.1031(ok)-1(g)(4)? Did Consumer X interact in an trade or exchanges that will be categorised as a partnership transaction, and was it ambiguous as to who the precise taxpayer was within the trade?
As you delve into the chances and focus on with Consumer X and his counsel, it’s clear they have been unaware of the attainable pitfalls. You attain for ache relievers for a headache, since you weren’t concerned in documenting the exchanges. Forensic-like, you begin to determine with Consumer X and his counsel if the exchanges certified beneath the federal and state legal guidelines and pointers.
Get organized
To decode the transaction, you ask Consumer X whether or not or not an trade transaction guidelines and spreadsheet have been ready. The silence that follows your query provides you the reply. You clarify that an trade transaction guidelines and accompanying spreadsheets act as a roadmap for the trade or collection of exchanges (i.e., when there are cut up exchanges). Why depend on your reminiscence to trace the steps of an trade transaction when you will have many different purchasers and federal and state audits may very well be years off into the long run?
As in any transaction, checklists preserve monitor of important transaction dates, the events concerned within the transaction, the assorted duties, allocation of duties for these duties to the events concerned, and the transaction paperwork. The guidelines also needs to monitor different points, corresponding to whether or not or not consent is required beneath the phrases of the related company documentation if the taxpayer is an entity. At all times anticipate an audit, and put together a closing binder, both arduous copy or electronically, containing all the related buy and trade documentation. The binder needs to be listed so an auditor can simply discover the assorted paperwork, significantly these associated to the trade documentation.
For a ahead trade, the related paperwork would come with the next: an trade settlement, a belief settlement (if relevant), an task of relinquished property buy contract and spot of task, a relinquished property closing settlement assertion, a 45-day identification letter, task of substitute property buy contract and spot of task, a substitute property closing settlement assertion, and the middleman’s assertion of account monitoring trade stability funds.
The trade spreadsheet is significant to monitoring the historical past of the trade and is ready by the accountant. It ought to monitor the idea of the property, changes to the idea, determine all properties concerned within the trade along with the sale worth of the relinquished property and the acquisition worth of the substitute property, affirm whether or not the trade would adjust to the identification guidelines (e.g., 200% identification rule if relevant, three-property rule, 95% rule, and so on.), notice any recognized “boot” points (defined under), and specify proportion curiosity calculations if the properties concerned are a part of different cut up exchanges.
Get your workforce collectively. Any trade transaction ought to contain the consumer’s skilled workforce, consisting of counsel, accountants and principals. Many exchanges go awry as a result of there is no such thing as a workforce to behave as a test and stability on the assorted elements of the transaction and to lift points on the outset and in the course of the trade that might have an effect on the viability of the trade or exchanges.
Did the consumer fulfill the technical guidelines of a 1031?
Your consumer is extra possible than not going to be topic to an audit if it has didn’t fulfill the technical guidelines for a 1031 like-kind trade. As a threshold matter, the properties concerned within the trade should meet the necessities of a “like variety” actual property curiosity beneath the TCJA. The property should be held and utilized in a productive commerce or enterprise or as an funding for sure time intervals, and the important trade transaction dates, the 45-day identification interval and the 160-exchange interval should be intently adhered to.
To keep away from “boot” points, the substitute property should be of equal or increased worth than the relinquished property and all relinquished property trade proceeds should be reinvested into the substitute property. Lastly, the consumer should report any “boot.” Within the case of Consumer X, you be taught that what could have triggered the audits was the truth that the consumer had not unambiguously recognized the substitute property. Consumer X had meant to amass a fractional curiosity in a substitute property however didn’t determine that curiosity. Because the topic trade was an enchancment trade, Consumer X additionally didn’t particularly determine the enhancements that have been meant to be made to the true property.
You then uncover that Consumer X has one other audit downside and has made an trade of partnership pursuits in an entity, which is particularly prohibited by Part 1031(a)(2)(D), no matter whether or not the pursuits exchanged are normal or restricted partnership pursuits. Each the state and federal auditors examined the acquisition contracts for the exchanged properties, the entity documentation, and the task provisions within the buy contracts. Moreover, the auditors famous that there have been anomalies within the supply of the funds utilized by Consumer X’s exchanging entity to facilitate the trade. As Consumer X discovered, deferred achieve from California relinquished property should be sourced to California, no matter the place the substitute property is situated.
This concern may have been resolved in any of 3 ways, and every one among these strategies may very well be the topic of separate articles: distribute an undivided curiosity within the partnership, a “money out” of sure companions who don’t wish to trade into different actual property curiosity; liquidate the partnership and switch the true property to tenancy in frequent pursuits (topic to with the ability to fulfill the “held for productive use in commerce or enterprise or for funding functions” necessities); “drop and swap” (distribution of the true property pursuits to the companions previous to the trade) or “swap and drop” (distribution of the true property pursuits to the companions after the trade). Consumer X didn’t avail himself to any of those choices, and failure to take action beneath federal and tax necessities may topic him to civil and/or prison penalties.
Who could be a certified middleman?
Consumer X’s issues with the trade are usually not over but. The IRS has questioned the validity of the middleman Consumer X used. A professional middleman is outlined beneath the Treasury rules as an individual who will not be the taxpayer or a disqualified particular person, who enters right into a written settlement (the “trade settlement”) with the taxpayer to amass the relinquished property from the taxpayer, switch the relinquished property, purchase the substitute property, and switch the substitute property to the taxpayer. A professional middleman is outlined beneath the rules as any one that will not be the taxpayer or a disqualified particular person. Disqualified individuals embrace any social gathering that had a monetary relationship and acted on the taxpayer’s behalf in coping with a 3rd social gathering in the course of the earlier two years, in addition to a associated social gathering.
After the losses suffered by taxpayers in the course of the Nice Recession, some states handed laws that set restrictions and licensure requirements for insurance coverage and escrow or belief account possession. Right here, the independence precept is paramount, and it turns into obvious that Consumer X didn’t comply with the rules however as a substitute chosen his brother-in-law, who can also be his enterprise associate, to behave as a professional middleman.
You advise Consumer X and his counsel on the perfect practices going ahead to keep away from future audits (or move them with flying colours), somberly shut your briefcase, and kit up for the audits forward.
