BusinessReport.com

Anyone pursuing “aggressive tax strategies” with investment properties should beware. The Internal Revenue Service is watching more closely.

Prompted by a recent U.S. Department of Treasury report urging more oversight, the IRS agreed to scrutinize “like-kind” or “1031” exchanges, named after a section of the IRS Code. Investors use the exchanges to defer —or possibly avoid—capital gains taxes when they sell a business or investment property and then replace it with a similar asset in a certain amount of time.

“The IRS intends to increase its review of what they consider to be aggressive tax deferral strategies including those subject to Section 1031 of the Internal Revenue Code,” says David S. Gunn, CPA and attorney with Gunn & York Attorneys and the 1031 Exchange Co.

“Increased scrutiny of abusive techniques is absolutely warranted,” Gunn says. The increased scrutiny is partly because of companies acting as intermediaries with these exchanges “that are less than honorable,” he says. As a result, the U.S. Department of Justice is urging investors to be cautious in choosing a “1031” company.

Any investor doing an exchange has to place the money with an intermediary like Gunn, who sets up an account and holds the money from the sale until it is reinvested. But Gunn says, when they approached some of these companies, many on the East Coast, they couldn’t get their money back.

Gunn says investors who follow the law should not be concerned. “The government is not challenging a basic 1031 exchange transaction.”

But both Gunn and Bill Hyde, general counsel with Title Exchange Co., agree there should be concern about certain kinds of exchanges such as those related to second homes and vacation homes.

“The exchange of personal vacation homes is of interest to the IRS,” Gunn says.

Hyde says he was aware of the IRS tightening up on exchanges, particularly on compliance, because he recently received a copy of the Treasury audit.

According to the report:

l axpayers (including individuals, partnerships and corporations) filed more than 338,500 exchanges claiming deferred gains or losses of more than $73.6 billion in 2004. “While this represents a doubling of the number of like-kind exchanges reported in 1998, the total dollar amounts deferred more than tripled. “There appears to be little IRS oversight of the capital gains (or losses) deferred through like-kind exchanges.”

l RS regulations for exchanges on second and vacation homes are complex and possibly unclear to taxpayers. “The absence of clarification leaves unrebutted the sales pitch of like-kind exchange promoters who may encourage taxpayers to improperly claim deferral of capital gains through ‘tax-free’ exchanges.’”

l he IRS agreed to study reporting and compliance issues with the exchanges, to revise instructions on certain tax forms, update this information on its Web site, as well as to provide additional guidance to taxpayers, practitioners and stakeholders. It also urges taxpayers to keep documentation on these exchanges.

Hyde, who has handled 1031 exchanges for nearly 20 years, says the law is clear, but instructions on how to handle them are not, and the IRS hasn’t been able to adequately answer past 1031 questions.

Section 1031 has been in the tax code since it was established in the 1930s, he says. It was intended to allow deferring gain on investments until the cash came to pay the taxes. The exchanges only apply to real estate and other tangible assets such as equipment that can include helicopters or crew boats.

“Real estate investors use it more than ever and they have, through artistic devices, made transactions qualify under 1031 that may or may not have been contemplated in the 1930s,” Hyde says. “The industry is solid from the standpoint that the code provision providing for it existed when the code was written, however, the legislative and case history of matters in this area have broadened the scope and impact of the concept in so far as it being reduced revenue for the government and it’s been under the gun for a long time.”

While Hyde and Gunn say the IRS has unsuccessfully tried to restrict these exchanges in the past, they also say restrictions are possible this time.

“They will probably close areas they consider to be testing the envelope on 1031s, such as TICs [tenant-in-common properties],” Hyde says.

A TIC is similar to a real estate investment trust where an investor can buy a small interest in a large real estate project. Security brokers typically sell TICs. But Hyde says some members of Congress have begun to question their validity as a replacement property and that could also invite restrictions.

John Adams, vice president and Prairieville branch manager for Land America Lawyers Title that also handles 1031s, says he’s observed some confusion with people who flip property in this area. Several have tried to claim their houses as investment property, but Adams says it’s actually inventory and doesn’t qualify for an exchange.

Blanche Cano, a Realtor with C.J. Brown, says most of her clients do exchanges because they’ve moved out of the area and find it difficult to be a “long-distance landlord.” Some investors do them to swap properties from a depreciating area to an appreciating one, which qualifies for an exchange as long as it’s a like-kind property or combination of them.

In her 10 years of doing exchanges, Cano says she’s also seen the IRS periodically tighten on the exchanges with little effect.

Gunn agrees the government is doing more audits of them. “When it moves from one income return out of 130 to 1 out of 100, the question is, ‘Is that real progress?’”