In September of 2007, the Inspector General of the US Treasury issued a report criticising the IRS for their oversight of Section 1031's. Well, the IRS has just responded. Can we expect increased scrutiny of Section 1031 exchanges now? Time will tell, but the IRS issued a Fact Sheet in response to the Inspector General's criticism.

IRS' Fact Sheet:
http://www.irs.gov/newsroom/article/0,,id=179801,00.html

Original report from inspector general:
http://www.ustreas.gov/tigta/auditreports/2007reports/200730172_oa_highlights.pdf

Section 1031 Exchanges - Shots Fired Across the Bow

If you are a practitioner in real estate or have clients that hold real estate, the state of California recently made some noise that should make you stand up and take notice. Section 1031 Exchanges, long considered one of the most powerful tax advantages in real estate investing, allow real estate investors to sell their investment properties and "exchange" them for a "like-kind" investment and defer the tax on the accumulated capital gains. This can be repeated over time until the final property is eventually sold and taxes paid. States generally permit similar tax treatment to the federal code for investments made within their boundaries. The Code, however, seems to be coming under increasing scrutiny at federal and state levels, with California being the latest to attempt to nibble at the edges of the Code to reduce its effectiveness as a tool.

In an effort to raise an additional $2.7 billion dollars in tax revenue, California Legislative Analyst's Office (CLAO) has recommended, among a list of other potential initiatives, to eliminate exchanges for "out-of-state" properties. While real estate is just one of the asset classes that are allowed to be exchanged under the code, it represents the lion's share of eligible assets.

It is understandable that California would consider this change. First and foremost, California investors, significant beneficiaries of appreciated real estate over the past decade, have long been some of the biggest players in Section 1031 exchanges. While California has been a great state to invest in real estate, it has never been considered the friendliest tax state in the country. California is a state that has an instituted income tax and investors need to include in their analysis the effects California's taxes have on their returns. Undoubtedly, savvy California investors that are looking to mitigate their tax liabilities are at least considering exchanging their investments in to lower or no-tax states, such as Florida or Texas, two states that have also benefited from higher than average appreciation. If the investor chooses to move the asset and exchange out of California, the tax obligation to the state is not necessarily erased. According to CLAO, deferred capital gains taxes, however, are rarely, if ever, reported to the state, once the investment leaves the state's borders. So, in a nutshell, it is easy to see that California stands to gain substantial tax revenue potential by clamping down on Section 1031 exchanges. CLAO estimates that the state could produce an additional $25 million in 2008-09 and $50 million in 2009-10 by restricting the current rule.

Why does this matter to anyone but California real estate investors? Most states across the country have implemented state income taxes. It is expected that many of the remaining states' legislatures will follow California's lead to chip away at the benefits of Section 1031 and this action would give investors pause to think about leaving their states' boundaries before paying the tax man, ultimately causing a trickle effect throughout the nation. The niche cottage industry that serves Section 1031 investors, namely real estate brokers, attorneys and qualified intermediaries, strongly oppose restrictions being placed on one of their largest pools of clients. Section 1031 exchange proponents are already feverishly at work trying to keep CLAO's suggestion from becoming a rule change. Stay tuned, because this could get interesting, not just for California, but for real estate investors nationwide.