What Happens if the IRS Rejects Like-Kind Exchange Treatment Under Section 1031?

Conducting a like-kind exchange with the help of a 1031 qualified intermediary provides an opportunity to indefinitely defer tax liability on gain realized from the exchange. When seeking to take advantage of indefinite tax deferral under Section 1031, taxpayers are responsible for assessing their eligibility, and then they must report the exchange to the Internal Revenue Service (IRS) using Form 8824.

So, what happens if a taxpayer gets it wrong?

Improperly claiming an indefinite tax deferral under Section 1031 can have serious consequences. While intentionally submitting a fraudulent Form 8824 can create exposure to criminal penalties, even inadvertent mistakes can trigger substantial civil liability. As a result, it is critical that taxpayers take the necessary steps to ensure (and document) their eligibility before claiming a like-kind exchange.

Potential Consequences of Improperly Claiming a 1031 Exchange

If the IRS disallows indefinite tax deferral under Section 1031 for a purported like-kind exchange, the potential consequences can include (but are not necessarily limited to):

Immediate Tax Liability on the Realized Gain

When a taxpayer improperly defers tax on gain from the sale of appreciated real estate, the taxpayer’s unpaid tax liability becomes immediately due and payable. Thus, once the taxpayer discovers the error (or is informed of the error by the IRS), the taxpayer must promptly pay the tax owed.

Of course, if the taxpayer has already reinvested the proceeds from the exchange in a new property, this could prove challenging. However, this is not the IRS’ concern. As a result, if a taxpayer cannot immediately pay the unpaid tax due, the taxpayer will need to consider the options that are available for avoiding further consequences. Depending on the circumstances, these may include submitting an offer in compromise, entering into an installment agreement or seeking currently-not-collectible status, among others.

Accuracy-Related Penalty

The IRS imposes an accuracy-related penalty when a taxpayer pays some, but not all, of the tax owed in a given tax year. This penalty can be as high as 20 percent of the amount due. Given that like-kind exchanges often involve substantial potential tax liability, this penalty has the potential to be substantial as well.

Failure-to-Pay Penalty

The IRS imposes a failure-to-pay penalty when a taxpayer does not pay taxes in a given tax year. If a taxpayer’s only potential tax liability arose out of an attempted like-kind exchange, the failure-to-pay penalty may apply. This penalty is calculated as “0.5% of the unpaid taxes for each month or part of a month the tax remains unpaid,” subject to a maximum penalty of 25 percent.

Interest on Past-Due Taxes and Penalties

Unpaid taxes and penalties both begin accruing interest immediately. The IRS makes this clear, stating, “[we] charge[] underpayment interest when you don’t pay your tax, penalties, additions to tax or interest by the due date.” As the IRS also makes clear, “[it] doesn’t generally abate interest charges and they continue to accrue until all assessed tax, penalties, and interest are fully paid.”

Criminal Penalties for Tax Fraud

As noted above, criminal penalties can also apply in some cases. For example, under the federal tax fraud statute, any taxpayer who “willfully attempts in any manner to evade or defeat any tax” can face up to a $100,000 fine ($500,000 for corporations) and up to five years of federal imprisonment. Depending on the circumstances involved, other criminal penalties may apply as well.

How Can You Avoid These Consequences When Conducting a Real Estate Exchange?

With these consequences in mind, what can (and should) taxpayers do to ensure that they qualify for like-kind exchange treatment under Section 1031 when buying and selling real estate?

Working closely with a 1031 qualified intermediary is a critical step toward ensuring compliance with the Internal Revenue Code. An experienced 1031 qualified intermediary will be able to assess your proposed transaction’s eligibility for like-kind exchange treatment and assist with structuring the transaction to establish eligibility if necessary. Depending on the circumstances, this may involve carefully structuring a reverse or delayed exchange. Your 1031 qualified intermediary will also be able to assist with managing the exchange and ensuring that you have the documentation you need to withstand IRS scrutiny if necessary.

Considering a Like-Kind Exchange? Schedule a Call with a 1031 Qualified Intermediary Today

If you are considering a like-kind exchange and would like to know more about the services a 1031 qualified intermediary can provide, we invite you to get in touch. Call 888-872-1031 or contact us online to schedule a free consultation at 1031 National Services.