The Internal Revenue Service is stepping up scrutiny of a popular tax strategy used by real-estate investors.

IRS officials agreed to take action in response to a report by a Treasury Department unit urging the agency to improve its oversight of like-kind exchanges.

Lawyers and accountants often refer to this as "1031" exchanges, named after a section of the Internal Revenue Code. These exchanges generally allow participants to defer, or sometimes even avoid, capital-gains taxes when they sell a business or investment property and replace it with a similar asset within a specified period. Some people have used the basic concept to defer taxes on gains in other types of property, including art and collectibles.

The report, issued by the Treasury Inspector General for Tax Administration, urged the IRS to do a better job of explaining the rules to taxpayers. The authors of the report also said clearer guidance will help deter unscrupulous promoters from trying to abuse the system..

The use of like-kind exchanges has surged over the past decade as real-estate investors searched for legitimate ways to postpone, or avoid, taxes on big gains. According to the Treasury report, taxpayers filed more than 338,500 forms reporting like-kind exchanges in 2004, deferring more than $73.6 billion. That represented a doubling of the number of like-kind exchanges reported in 1998. The total dollar amount deferred "more than tripled" in that time period.

These totals include not only individuals but also partnerships and corporations. The report said individuals accounted for 65% of the forms filed and 39% of the dollar amount.

Bruce Friedland, an IRS spokesman, said the agency agrees with the report's recommendations and will be revising form instructions, publications and other communications. Kathy Petronchack, who heads the IRS's small business/self-employed division, said the agency will do a "research study" of "reporting and compliance issues" involving like-kind exchanges.

In the wake of the Treasury report, "I think you can expect increased IRS enforcement and oversight activity," said Louis Weller, national director of real-estate transaction planning for Deloitte Tax LLP in San Francisco. IRS officials are "aware of a lot of pushing-the-envelope activity by taxpayers."

The report said IRS staff reported "potential abuses," such as transactions involving properties that aren't "like-kind," or exchanges with "related parties," or "incorrect property basis figures."

The Treasury report said more oversight is needed. "There appears to be little IRS oversight of the capital gains [or losses] deferred through like-kind exchanges."

The authors said it seems "the IRS is relying on taxpayers to voluntarily comply with the tax law" in this area.

Mr. Friedland of the IRS said the agency "urges taxpayers to keep documentation on hand to substantiate 1031 exchanges and any other transactions." That documentation "is critical if the IRS has questions," he said.

Improving the IRS's published guidance to taxpayers could help avoid abuses, the report indicated. Consider second-and-vacation homes.

A second or vacation home used exclusively by the owner doesn't qualify for like-kind treatment, which applies to property held for business or investment use, the report said. But IRS rules and regulations for exchanges of second-and-vacation homes that aren't used exclusively by the owners, or where there is some rental history or attempts by the taxpayer to rent the properties, are "complex." The report said, moreover, that "little exists" in the way of published material by the IRS to explain its position.

This is a timely issue given the real-estate market's slump. The report said some "may see this as an opportunity to invest in second-and-vacation homes at reasonable prices." Given the lack of regulations, statutes and court cases in this area, taxpayers and promoters "may mistakenly take the position that any transaction not specifically prohibited by IRS guidance would be entitled" to like-kind exchange treatment, the report said. "Unscrupulous or uninformed promoters" already are taking advantage of the IRS's "silence" on this subject. "For example, one promoter advised that taxpayers could sell their vacation homes using like-kind exchanges even though the homes were never rented."

The IRS agreed there is no guidance now on the issue of like-kind exchanges regarding second-and-vacation homes that aren't used exclusively by the owner. For this reason, the division has asked the IRS's lawyers for guidance.

BY WALL STREET JOURNAL®

Real Estate Vocabulary Builder:
Appreciation:
The increase in the value of a property due to changes in market conditions, inflation, or other causes.

Cash-out refinance:
When a borrower refinances his mortgage at a higher amount than the current loan balance with the intention of pulling out money for personal use, it is referred to as a "cash out refinance."


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