"Formality" of 1031 Exchange Process

[Mike Nas]

Hello BP family, I had question about 1031 and reverse 1031 exchanges. I know this is  an oversimplification, but coming from a legal background Im trying to understand whats going on in a 1031. My impression of the process is that its kind of "informal" in the sense that it really only involves the exchanger and QI with the idea being  that the transaction is being properly documented (such as identifying a prop w/in 45 days) and structured (i.e. making sure the exchanger doesn't receive or control both properties or proceeds) in accordance with IRS rules. Once the transaction is complete you would file your yearly taxes and indicate the sale but defer payment of cap gains taxes on the basis of the 1031. 

With that said, is it correct to say the IRS (or govt for that matter) doesn't get involved unless you're basically being audited/investigated? The documents used specifically for the 1031 (such as the Exchange agreement or writing identifying props to acquire) are not sent or filed with the IRS/govt; they are more important after the fact to demonstrate and prove to Uncle Same why capital gains were not owed on that transaction, should an audit occur? Is it correct to say that there is basically no affirmative "approval" received when doing a 1031; there is really only a disapproval of one in the form of a failed audit.  

[Whitney Nash]

Hello @Mike Nas

What you wrote is essentially correct. While there is no formal "approval" process involving the IRS/govt during an exchange, all of the steps, people (QI), and documents involved in executing an exchange are required formalities. They MUST be apart of the formal exchange process or it doesn't exist and will fail. As @Jeff Nash explained, when filing their taxes and reporting the exchange on Form 8824 the CPA/tax preparer will need a copy of the exchange documents, closing statements (which also have 1031 language on them), etc. to report it properly. If not reported properly the likelihood of an audit increases. Also, a qualified intermediary helps the client execute an exchange according to the rules/laws to help mitigate any potential for a future IRS disapproval. They will make determinations/give advice along the way that are essentially approvals/disapprovals so that the client doesn't do something that they shouldn't which could cause the exchange to fail and be taxable.