Did You Buy Substantially The Same Property That You Identified In Your 1031 Exchange?

I know, I know.  You are wondering what I've been drinking.  But, this is a real issue.  In fact, It is a really critical issue when you are being audited.

It does in fact come up during income tax return audits, especially when the California Franchise Tax Board is the audit agency.  The California Franchise Tax Board has been taking very hard look at just this issue.  We've been brought in as 1031 Exchange experts on audit cases for this very issue. 

Actual Case Study
Let's look at an audit case that we recently consulted on.  The investor/taxpayer sold a property ("relinquished property") and structured a 1031 Tax Deferred Exchange transaction.  The investor/taxpayer identified his intended purchase ("replacement property") within the required 45 calendar day identification period.

His identification read like this: 12345 Main Street, Anytown, CA 92345

He made an offer, which was accepted, to buy an undivided ten percent (10%) interest in his identified property, and he actually closed on the purchase of the fractional interest well within his 180 calendar day exchange period.

Acquiring Substantially The Same Property
The issue is this, by identifying the property as 12345 Main Street, he has effectively identified 100% of the property as his intended replacement property.  However, he only acquired a ten percent (10%) interest in the property. 

The question then becomes, did he actually acquire substantially the same property as the property that he identified if he only acquired ten percent (10%) of what he actually identified. 

I know, I know, this is like splitting hairs.  But, the California Franchise Tax Board is taking this very position right now.  They have disqualified the 1031 Exchange under audit because he did not acquire substantially the same property that he identified. 

Investors/taxpayers structuring 1031 Exchanges must be very, very careful when identifying their intended like-kind replacement properties so that they do not run afoul of the hyper-critical taxing authorities today. 

Backdating the Identification Form in Your 1031 Exchange

You are probably very familiar with the 45 day identification period if you have ever completed a 1031 exchange transaction. The taxpayer must identify in writing the potential replacement properties that they are considering buying as part of their 1031 exchange transaction, and the identification must be made with in 45 calendar days of the closing of the relinquished (sale) property.

45 Day Period Moves Fast
The 45 day identification period moves very quickly. In fact, it is only six weekends, which is not a lot of time to search for suitable like-kind replacement properties for your 1031 exchange. Taxpayers should start looking for replacement property well before they have closed on their relinquished properties to help minimize the stress involved with the 45 day ID period.

It is not surprising that many taxpayers may get a little stressed out during the 45 day identification process and time period. O.K. That might be an understatement in certain cases, especially as the taxpayer gets to the end of his or her identificatio period.

Backdating or Altering the Identification Form
Actually, my favorite question is "what is your position on the 45 day period?" I can't actually say this, but I really want to respond with "Are you kidding me?" The 45 day identification requirement is contained with the Internal Revenue Services, the Treasury Regulations and in numerous IRS rulings and court decisions. I think it is just about as clear as it can be that you must identify no later than midnight of the 45th day. There is no gray area here.

"But, ABC Exchange Company will allow me to backdate my identification form." "Nobody ever gets caught." These are some of my favorate follow-up comments that we get after we inform them that there is no flexibility with the 45 day identification requirement, even though we wish there were.

It's Tax Fraud; Pure and Simple
I realize that the IRS has been very loose in its enforcement of this area, but it will happen at somepoint in time. The act of backdating, altering or amending your identification form after the end of yoru 45 day identification period is tax fraud. There is no gray area.

I don't know about you, but I certainly do not want to be the poster boy for the IRS when they decide to actually prosecute some of these cases.

It is the same as the mortgage fraud was going on for years, which is part of the reason we are n the mess that we are in now. Clients used to respond all the time that no one ever gets caught if they say it was owner occupied when in fact it was rental property. We would still warn them. Well, the FBI is investigating and prosecuting those who lied right now. Its fraud, period.

Do you really want to take the chance that you might be the one that gets caught? More importantly, do you really want to work with a 1031 exchange company that is routinely breaking the law? I would prefer that they be around for a long time so that they are there for me if I get audited. Just my two cents.