What is Required to Provide Reasonable Cause Penalty Protection for 1031 Clients?

For purposes of federal tax law*, a Tax Shelter is defined as a partnership or other entity, or any investment plan or arrangement (e.g., investment), if a "significant purpose" is the avoidance or evasion of federal income tax.

Typically, a taxpayer chooses to enter into a Section 1031 exchange for a significant, if not the sole, purpose of deferring income taxes on the sale of investment or business property.

If a 1031 exchange is completed incorrectly, or reported incorrectly, then the client will owe the taxes plus "20% understatement of tax" penalty. This penalty is defined under Section 6662 for errors and mistakes made in a Section 1031 exchange.

In the past, the taxpayer was provided with "reasonable cause penalty protection". The taxpayer was protected from the penalty if the taxpayer stated that he/she relied on the advice of a professional, and that advice was reasonable cause for the error in the 1031 exchange. Now, based on changes to section 6662, the rules have changed. In order for a non-corporate taxpayer to avoid the "20% understatement of tax" penalty, the taxpayer must establish several facts, including:

In contrast a corporate taxpayer cannot avoid the "20% understatement of tax" penalty with either reasonable reliance or disclosure.

There are two significant changes to Circular 230 (the IRS rules for the governance of the tax profession). First, a written tax opinion is now required for any transaction having either its principal or significant purpose of the reduction, avoidance or evasion of any tax imposed under the Code. Second, the taxpayer's professional advisor must be an expert in that area of federal tax law (e.g., Section 1031 exchanges).

In the past, professional advisors would provide the taxpayer with a disclaimer. Now, this disclaimer strips the taxpayer of their penalty protection.The question is whether clients may sue their Advisors for intentionally stripping them of their penalty protection with the use of a disclaimer.

At Strategic Property Exchanges, we do not use disclaimers. We have a full time attorney, who is certified by the Ohio Bar Association as a Specialist in Federal Tax Law and who provides clients with written tax opinions. We will provide you with the support and knowledge necessary to comply with the IRS regulations, as well as strengthen the relationship between your firm and your client.

* Section 6662, Section 6662(d)(2)(C)(ii).

Stephen L. Robison, J.D., LL.M.





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More than just commercial property can be exchanged in a 1031 process. To learn more about the other items, read our page on What can be exchanged?