Examination and Litigation

The organizing observation is that almost every advantage in an examination is created at closing and almost none of it can be created afterward.

54.1 Audit selection and common adjustments

The transaction reports itself. A Form 8824 is an affirmative statement that a taxpayer disposed of appreciated property and recognized little or no gain, filed alongside a return that shows the proceeds nowhere. The form is also short, arithmetically self-contained, and easy to compare against the settlement statements a title company reported.

Six adjustments account for most exchange examinations, and each corresponds to a chapter of this work.

Qualifying use. Whether the relinquished property was held for productive use in a trade or business or for investment, and whether the replacement property is so held. This is the most common adjustment and the one least susceptible to documentary cure after the fact. Chapter 12.

Identification. Whether the identification was timely, properly delivered, unambiguous, and within the numerical limits, and whether an amended identification revoked the earlier one. Chapter 25.

Receipt and control. Whether the taxpayer had rights to the funds that the agreement should have limited, and whether proceeds passed through a person who was the taxpayer's agent. Chapters 27 and 29.

Boot and debt. Whether net debt relief was computed correctly and whether the asymmetric offsetting rule was applied in the right direction. Chapters 33 and 34.

Related parties. Whether the replacement property came from a related person, directly or through an intermediary, and whether the two year condition held. Chapters 40 and 41.

Basis and depreciation. Whether the substituted basis was computed and allocated correctly, and whether the exchanged basis continued the relinquished property's recovery period. Chapters 35 and 36.

The practical point about selection is that an examination of one of these usually becomes an examination of all of them, because the same file answers every question. A well assembled file shortens the process and a missing one lengthens it regardless of the merits.

54.2 Burden of proof on intent

The contested issue in most exchange examinations is a state of mind: what the taxpayer intended to do with the property. That places the burden where it is hardest to carry.

The burden may shift, and the conditions are demanding. Where a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining liability, the Secretary bears the burden of proof on that issue.¹ But the shift applies only if the taxpayer has complied with the substantiation requirements of the Code, has maintained all required records, and has cooperated with reasonable requests for witnesses, information, documents, meetings, and interviews.²

Read those conditions against Chapter 37.4. A taxpayer who cannot produce the depreciation schedules, the settlement statements, and the Forms 8824 for a chain of exchanges has not maintained all required records, and the shift is unavailable on that ground alone, before any question of credible evidence arises.

What proves intent. Because intent is proved by conduct and by contemporaneous statements, the evidence is the same evidence identified throughout this work.

Documents created when the decision was made. A memorandum recording why a property was acquired, an engagement letter reciting an exchange objective, board minutes of the kind the regulation's own example treated as dispositive at 44.2.

Conduct consistent with the stated purpose. A property held for investment was insured as such, reported as such, offered for rent, or held without personal use.

The absence of contradictory documents. Marketing materials describing a property as a personal retreat, correspondence discussing a resale before acquisition, and loan applications reciting an intended use are the government's best evidence and they come from the taxpayer's own file.

What does not prove intent. An affidavit executed during the examination, a reconstruction of reasons, and a tax opinion. None of these is worthless, and none of them is contemporaneous.

The counsel that follows is the one this work has repeated in nearly every Part. The file is built at closing. An hour spent then is worth many days later, and there is no substitute available afterward.

54.3 Statute of limitations

The ordinary period is three years after the return was filed, and a return filed early is treated as filed on the last day prescribed.³

Three extensions matter in exchange practice.

Six years for a substantial omission. Where the taxpayer omits from gross income an amount properly includible that exceeds twenty five percent of the gross income stated on the return, the period is six years.⁴

The provision that makes this dangerous for exchanges is definitional. An understatement of gross income by reason of an overstatement of unrecovered cost or other basis is an omission from gross income.⁵ Basis is exactly the item an exchange chain makes contestable. A taxpayer who overstates the basis of replacement property, by computing the substituted basis of Chapter 35 incorrectly or by failing to reduce it for a prior deferral, has potentially converted a three year exposure into a six year one on a later sale.

Note also the disclosure rule and its exception. Amounts adequately disclosed on the return or an attached statement are not taken into account in determining the amount omitted, other than in the case of an overstatement of unrecovered cost or other basis.⁶ Disclosure does not cure a basis overstatement for this purpose.

Unlimited where the return is false or fraudulent with intent to evade tax, or where no return is filed.⁷

Open by agreement. The period may be extended by written consent before it expires.⁸

One provision keeps a year open by the taxpayer's own act. Where the involuntary conversion election of Chapter 45 is made, the assessment period for any year in which part of the gain is realized does not expire before three years after the Secretary is notified of the replacement or of an intention not to replace.⁹ The taxpayer closes that year by giving the notice, and a taxpayer who never gives it has left the year open indefinitely.

A practical consequence for exchange chains. The three year period runs from each return, but the facts that matter reach back much further. An examination of a current year sale requires establishing the basis produced by an exchange completed twenty years earlier, and the closed status of that earlier year does not relieve the taxpayer of proving the basis it produced. Limitations protect against assessment; they do not supply substantiation.

54.4 Penalties and reasonable cause

The ordinary penalty is twenty percent of the portion of an underpayment attributable to, among other things, negligence or disregard of rules or regulations, or a substantial understatement of income tax.¹⁰

Negligence includes any failure to make a reasonable attempt to comply, and disregard includes any careless, reckless, or intentional disregard.¹¹

An understatement is substantial where it exceeds the greater of ten percent of the tax required to be shown on the return or $5,000.¹² For an exchange of any size that threshold is met by definition once the deferral is disallowed.

Two defenses reduce the understatement itself, and they operate before any reasonable cause analysis.

The understatement is reduced by the portion attributable to the treatment of an item for which there is or was substantial authority.¹³

It is also reduced by the portion attributable to an item where the relevant facts affecting its treatment are adequately disclosed in the return or an attached statement and there is a reasonable basis for the treatment.¹⁴ Neither reduction applies to an item attributable to a tax shelter.¹⁵

The practical instruction is that disclosure is cheap and it converts a substantial understatement question into a reasonable basis question. Where a structure is aggressive, and particularly where it departs from the safe harbors of Part VI, disclosure should be considered at the time the return is prepared rather than discussed after a notice arrives.

The general defense is reasonable cause. No penalty is imposed under the accuracy related or fraud provisions with respect to any portion of an underpayment if it is shown that there was reasonable cause for that portion and the taxpayer acted in good faith.¹⁶

With one exception that this work has already flagged. That defense does not apply to any portion of an underpayment attributable to a transaction lacking economic substance.¹⁷ The penalty for such a transaction is twenty percent, rising to forty percent where the relevant facts were not adequately disclosed,¹⁸ and it is strict liability. An opinion of counsel does not reach it. The point is developed at 42.3 and it should be described to a client in those terms.

The fraud penalty is seventy five percent of the portion of an underpayment attributable to fraud, and where the Secretary establishes that any portion is attributable to fraud, the entire underpayment is treated as attributable to fraud except to the extent the taxpayer establishes otherwise.¹⁹ That burden-shifting rule is why a transaction with one indefensible element endangers the treatment of every other element.

How to think about the exposure as a whole. A failed exchange on a $2,000,000 gain produces the tax computed in Chapter 37, plus interest from the original due date, plus twenty percent of the underpayment in the ordinary case. Where the structure is one the Service has announced it will challenge, as in Chapter 41, or where the economic substance doctrine is invoked, the reasonable cause defense narrows or disappears. The client should be given those three numbers before the transaction, not after, because the decision the client is actually making is whether the deferral is worth that exposure.