AICPA Insurance Programs

Risks of IRC §1031 Exchange

The statutory and regulatory requirements to qualify a like-kind exchange transaction for tax purposes (single or multi-asset) are technically complex and require strict compliance (i.e. form over substance). An unintentional misstep along the way may disqualify a transaction for tax deferral treatment.  A CPA engaged in assisting clients with IRC §1031 (1031) transactions must be familiar with the applicable federal and state statutes and regulations and the resulting impact on other taxes that stem from these transactions, such as state/local income tax, sales/use tax, real estate excise tax, and property transfer tax. Further, the wide variety of 1031 exchange strategies and services (i.e. forward and reverse exchanges, construction exchanges, going business exchange, and tenancy-in-common ownership) offered by accountants, lawyers, and exchange facilitators provide further complications.

This article discusses some of the common causes of "failed" 1031 transactions, related malpractice claims, and how you can help clients avoid these problems. 

Claim Scenarios

In recent years, the number and types of 1031 exchanges have escalated. As the price of real estate soared, some clients bought and sold properties for speculation with the thought that the transactions would qualify as like-kind exchanges for federal and state income tax purposes. Ultimately, if the IRS deems the transactions to be a person’s trade or business with gains taxed as ordinary income and self-employment taxes due, clients may allege that their CPAs failed to give them adequate advice.    

The following are common claim scenarios and risk management tips related to 1031 exchanges:

Scenario 1:  An individual income tax client sold real estate and transferred the title without first seeking advice from his CPA. Upon learning of the transaction, the CPA informed the client about the additional tax liability incurred from the sale. The client alleged that the CPA did not give him adequate advice before the sale about structuring the transaction to meet 1031 exchange requirements.

Risk Management Tips:

• Before performing any services, including those related to 1031 exchanges, establish an understanding with the client in an engagement letter that covers the nature and limitations of the services you will provide, and a description of your responsibilities, your client’s responsibilities, and those of any other parties involved in the transaction. To the extent the client is engaging other professionals, such as lawyers and qualified intermediaries (QIs), to assist in completing the transaction, note this and explain that while you will cooperate with them in performing needed services, supervising their activities is the client's responsibility.
• If the client requests additional services during the engagement, amend the engagement letter or issue a separate engagement letter.

Scenario 2: During a casual conversation, a corporate tax client told her CPA she was considering entering into a 1031 transaction. The CPA explained the general rules applying to these transactions and indicated that based on the brief description provided, the transaction, as proposed, would qualify for a 1031 exchange. The client did not consult with the CPA further about the transaction and exchanged a parcel of land (real property) for an airplane (personal property).  When the client later discovered that the transaction did not qualify, she sued the CPA to recover the unexpected tax liability, alleging that the CPA gave her bad advice. 

Risk Management Tips:

• Acquire a high level of understanding of the technical statutory requirements, and obtain experience in dealing with 1031 transactions prior to providing services to clients.
• Obtain sufficient information about any proposed transactions (i.e. timing, the type of property to be relinquished/replaced) before providing any general advice.  Inform clients that your advice is based on the facts and assumptions provided and that your comments and conclusions may change if any of the facts change. Document your client discussions in writing and follow-up with a memo to clients summarizing your discussions. Avoid providing off-the-cuff tax planning advice generally, and specifically, when it pertains to a planned or proposed business transaction.

·         Educate clients about the different types of exchanges and the qualifications/requirements of like-kind exchanges. Consider including, for example:

• The types of property that would qualify for an exchange and those that are specifically excluded under 1031.
• The fact that both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Specifically indicate that a private residence (see IRS Rev. Proc. 2005-14) and property held for immediate resale does not qualify.
• The importance of not actually or constructively receiving cash. A client would have to recognize a taxable gain if boot (cash, unlike property, or debt relief) is received in addition to the like-kind property, if debt is assumed by the other party, or if there are unused proceeds after the transaction is completed.
• Other requirements, such as transaction timing, types of qualifying properties, valuation, property identification rules, and safe harbor rules.
• Discuss with clients the tax advice requirements of Circular 230 and the impact on your fees if they want you to issue an opinion letter on a proposed 1031 transaction.

Scenario 3: A CPA advised her client on a 1031 exchange and informed him about the timing requirements. After the transaction process began, the CPA did not follow-up with the client about the due dates because she thought it was the responsibility of her client’s attorney or QI. Subsequently, the exchange did not qualify for tax deferral treatment because it did not meet the 180-day timing requirement. The client claimed that he relied on the CPA to follow up with his other advisers about the deadlines.

Risk Management Tips:

• Suggest that clients plan ahead and research properties that they want to buy before implementing an exchange plan, thus facilitating the transactions within the required period. Make sure that clients understand that the deadline cannot be extended under any circumstances, even if the 45^th or 180^th calendar day falls on a Saturday, Sunday, or legal holiday.
• Meet with clients and other professionals engaged by the client in connection with planned transactions (i.e. client’s attorney and QI/accommodator) to develop a work plan for the exchange that includes timing, due dates, description of tasks to be completed, identification of the parties responsible for completing each task and preparing the necessary forms/documents, and any additional follow-up comments. Document all discussions in your working paper file, and provide a summary letter and an approved work plan to the client with copies to other participants.
• Be pro-active and schedule regular follow-up meetings or telephone conferences with clients and other involved parties to review the status of the work plan and to obtain documentation for your files that the required forms/documents have been executed and/or filed. Provide minutes of the meetings/conferences and an updated work plan to the client and other participants with specific notes that detail required follow-up and upcoming deadlines.
• If you become aware of outstanding or emerging issues that may impact meeting the exchange deadlines, contact the client and other involved parties promptly, and inform them both orally and in writing of your concerns and required follow-up.
• In the event the proposed exchange could be eligible for an alternative strategy that minimizes the risks associated with the transaction, discuss this with your client and document the discussion. For instance, in an exchange involving new construction, a reverse exchange could be structured to avoid the risk of construction delays and thereby mitigate the risks associated with IRC § 1031 time limitations.
• If you learn that a client or any other party has or plans to alter any of the document dates to meet the exchange deadlines, withdraw from the engagement immediately.

Some CPAs assume that other parties working with clients’ planned exchange transactions have discussed exchange-related issues with the clients or, alternatively, presume the issues are not sufficiently important to warrant discussing them. Even at the risk of being redundant, discuss any and all related or pertinent issues with clients.  These might include, for example, multi-asset exchanges, personal property issues, transfer taxes, state income tax withholdings, and the qualifications of a QI. 

Conclusion

A 1031 exchange gives a taxpayer an opportunity to defer taxes on the gain from a sale of property. However, there are multiple and complex tax issues and pitfalls embedded in these transactions and the governing gain deferral requirements. Clients need your assistance to plan a qualifying exchange and to understand the importance of adhering to the requirements. While there are risks associated with every business transaction, keeping clients informed about these requirements and remaining vigilant in following up on these matters and documenting both your understanding of the matter and the required follow-up helps to facilitate a successful exchange and minimizes your risk of a malpractice claim if an exchange fails to qualify for tax deferral.

Additional Resources:

• The Best of Both Worlds, by William Edward Allen III and  Mary B. Foster, Journal of Accountancy, August 2005
• Like-Kind Exchanges-Common Problems and Solutions, by Robert A. Briskin, The Tax Advisor, April 2005
• Reverse Exchanges Come of Age, by Ronald L. Raitz and Bridgette M. Raiz, Journal of Accountancy, August 2001

May 2006

By: Ellen VanDeLaarschot, CPA, Risk Control Consultant, CNA, Accountants Professional Liability, CNA Center, Chicago, IL 60685

The purpose of this article is to provide information, rather than advice or opinion. It is accurate to the best of the author knowledge as of the date of the article. Accordingly, this article should not be viewed as a substitute for the guidance and recommendations of a retained professional. Although based on actual cases, the scenarios depicted herein are fictitious. Any similarity to real people or cases is unintentional and purely coincidental. In addition, CNA does not endorse any coverages, systems, processes or protocols addressed herein unless they are produced or created by CNA.

Any references to non-CNA Web sites or articles are provided solely for convenience, and CNA disclaims any responsibility with respect to such Web sites. To the extent this article contains any descriptions of CNA products, please note that all products may not be available in all states. Nothing contained herein should be construed as acknowledgement by Continental Casualty Company that a given situation would be covered under a particular insurance policy.  To determine whether a specific situation may be covered, please refer to your policy.  Only the insurance policy can give actual terms, coverage, amounts, conditions and exclusions.

CNA is a service mark registered with the United States Patent and Trademark Office. Copyright 2006 CNA.  All rights reserved.

Executive Summary

• Professional liability claims relating to like-kind exchanges under IRC §1031 stem from clients’ stated reliance on the CPA to provide proper or adequate advice and to ensure that the transaction will qualify for tax-deferred treatment.
• Severe time constraints, inadequate planning, miscommunications, and complacency often cause exchanges to be disqualified for tax deferral purposes. CPAs can help manage malpractice risk from failed 1031 transactions by:
• Accepting a 1031 engagement only if they have attained a high level of technical competency and acquired considerable experience with 1031 exchanges before beginning to provide services. 
• Obtaining a signed engagement letter defining the responsibilities of all parties involved in an exchange transaction and any limitations on the services to be provided — before any services are provided.
• Maintaining current training about the technical requirements of 1031 exchanges and educating clients about these before a transaction is implemented.
• Assisting clients in properly structuring an exchange and closely monitoring the exchange work plan to ensure that technical requirements have been satisfied.
• Documenting all discussions with clients and other involved parties and being pro-active throughout the engagement regarding follow-up activities required by the client and other professionals associated with the transaction.