Section 1031 of the Internal Revenue Code allows a taxpayer to roll the gain from the sale of their Old Property over to their New, provided they do certain things which are detailed in the code. What most people don't understand is that Section 1031 is a "form driven" code section. This means that you must do exactly what the code section requires; if you don't your exchange will be disallowed if audited; you must dot the i's and cross the t's.
Over the years I've seen a lot of bad exchanges that squeaked by only because no one audited them. For example, I saw a bank intermediary on the west coast handle an exchange for a well known member of the movie industry without a set of exchange documents. I saw another intermediary tell their clients that they didn't have to submit their 45 day list until Monday if the 45 day deadline fell on a Saturday or Sunday.
I know of an intermediary that uses "a copy of a copy" of an exchange agreement that's been obsolete since 1995, and there are rumors in the industry of a good sized intermediary on the west coast that has never filed tax returns for the reverse exchanges it has handled. All of these examples are grounds for immediate disallowance of the exchange.
Part of the problem is the fault of the industry: there are no standards, no basic requirements, for qualified intermediaries; you don't have to take a class or pass a test to be an intermediary. As a result, there are people handling exchanges that simply aren't trained to do so.
Another part of the problem lies with the client/investor: most people doing an exchange are much more concerned about the cost of the exchange then they are about the quality of the exchange or the experience level of the intermediary. There seems to be a prevailing belief by the public that to have a good exchange you simply need a set of paperwork (and any old set will do) -- as long as you have some kind of paperwork, your exchange will be blessed.
And part of the problem lies with the IRS. In the past the IRS has stated that they haven't had a specific policy to target 1031 exchanges for audit, and until now, very few exchanges have been audited.
All of that is about to change. In 2007 the Treasury Inspector General for Tax Administration reviewed the IRS's handling of 1031 exchanges, and chided them for exercising very little oversight over the exchange process. In connection with its report it audited 6 large exchanges and assessed a total deficiency of $873 million! Its conclusion is that if the big dogs aren't following the rules, how bad must the smaller exchanges be? In response, the IRS has promised that it will begin an exchange auditing program.
The states are waking up to the problem also. Minnesota has adopted a policy of auditing 100 percent of all 1031 exchanges appearing in Minnesota tax returns, and has identified at least one Minnesota intermediary (a title company) that it considers to be so bad that they have an agent permanently camped in their office. California is also targeting 1031 exchanges, and more cash-strapped states are bound to follow.
States are getting into the legislative act as well -- requiring intermediaries to be licensed, bonded and demonstrate a minimum level of competency and education. Nevada recently passed such a law, and California, Colorado, Washington and Georgia are also looking at similar legislation.
What does all this mean to you and your clients? Well, as in most things, there's good news and there's bad news. The good news is that the bar will be raised and the intermediaries that you deal with in the future will be a lot more knowledgeable and ethical. The bad news is that you'll have a much smaller pool of intermediaries to choose from, and their fees will be much higher than they are now.
