What are the Penalties for Improperly Claiming a 1031 Exchange?

Conducting a 1031 exchange affords the opportunity to achieve significant—and potentially indefinite—federal tax savings. However, to achieve this tax savings, real estate investors and business owners must conduct their exchanges in strict compliance with Section 1031 of the Internal Revenue Code. Non-compliance with Section 1031 can have other financial consequences as well, making it critical to work with an experienced 1031 exchange facilitator throughout the process.

Understanding the Tax Consequences of a Disallowed 1031 Exchange

The Internal Revenue Service (IRS) can disallow tax deferral under Section 1031 if it determines that a purported like-kind exchange does not meet all statutory requirements. Crucially, however, this is not the only potential consequence of a disallowed 1031 exchange.

Real estate investors and business owners who improperly claim a 1031 exchange can face consequences including:

Capital Gains Tax

If an exchange does not meet the requirements for tax deferral under Section 1031, the exchange will trigger immediate capital gains tax liability (assuming the relinquished property was held for a year or longer). The tax owed will be determined based on the difference between the taxpayer’s basis in the relinquished property and the relinquished property’s sale price, among other pertinent factors.

Interest on Delinquent Tax Liability

Interest immediately begins to accrue on delinquent federal tax liability. If a taxpayer improperly claims a 1031 exchange—and fails to timely pay the capital gains tax due as a result—the taxpayer will owe interest to the IRS as well.

Accuracy-Related Penalty

The IRS’s accuracy-related penalty applies, “if you don’t report all your income or you claim deductions or credits for which you don’t qualify.” This penalty is either:

• “20% of the portion of the underpayment of tax that is attributable to negligence or disregard of rules or regulations;” or,
• “20% of the portion of the underpayment of tax” in the event of a substantial underpayment.

For individuals, a substantial underpayment is defined as “10% of the tax required to be shown on your tax return or $5,000, whichever is greater.” For corporations (other than S-corporations), the substantial underpayment penalty applies if “the amount of the understatement exceeds the lesser of 10% of the tax required to be shown on the tax return (or, if greater, $10,000), or $10,000,000.”

IRS Civil Fraud Penalty

Along with the accuracy-related penalty, other penalties may also apply depending on the circumstances involved. These can include the IRS’s civil fraud penalty. As the IRS explains, “[i]f there is any underpayment of tax on your return due to fraud, a penalty of 75 percent of the underpayment due to fraud will be added to your tax.”

Criminal Penalties

Criminal penalties can also apply in cases of suspected fraud. Under the criminal provisions of the Internal Revenue Code, willfully attempting to evade federal tax liability is a federal felony that carries up to a $100,000 fine ($500,000 for corporations) and five years of imprisonment.

How to Avoid Taxes, Interest and Penalties for a Disallowed 1031 Exchange

In light of these potential penalties, what can real estate investors and business owners do to avoid improperly claiming a 1031 exchange? Among other things, ensuring strict compliance with Section 1031 involves:

• Properly timing the sale of the relinquished property and the acquisition of the replacement property to facilitate a true “exchange;”
• Working with a 1031 exchange facilitator to ensure that you do not come into possession of the sale proceeds from the relinquished property too soon;
• If necessary, working with a 1031 exchange facilitator to structure a delayed exchange or reverse exchange that complies with the Internal Revenue Code’s requirements;
• Thoroughly documenting all aspects of the 1031 exchange process so that you are prepared to affirmatively demonstrate compliance to the IRS if necessary; and,
• Promptly paying tax on any “boot” from the transaction in order to mitigate your risk of facing scrutiny from the IRS.

By taking these steps (among others), real estate investors and business owners can fully comply with Section 1031 and achieve the maximum tax savings available. If you would like to know more about how to successfully conduct a 1031 exchange and avoid IRS penalties, we invite you to contact us for more information.

Get Help from an Experienced 1031 Exchange Facilitator – Schedule a Free Consultation Today

To get help from an experienced 1031 exchange facilitator at 1031 National Services, give us a call at 888-872-1031 or tell us how we can reach you online. We will schedule your free consultation at a time that is convenient for you.