What is the IRS audit risk on a 1031 exchange, and what records should I keep?

What the published coverage rates actually are, band by band

Table 3-1 of the IRS Data Book for fiscal 2025 is the only authoritative source on this, and it reports by the income size of the return, not by the schedules attached. For tax year 2021, which the Data Book identifies as the most recent year outside the normal assessment statute, coverage of individual returns was 0.3 percent overall: 0.6 percent for returns showing $500,000 to $1 million of total positive income, 0.9 percent from $1 million to $5 million, 3.9 percent from $5 million to $10 million and 6.6 percent above $10 million.

Older years run higher because more audits have closed. For fully mature tax year 2015 the same table shows 0.6 percent overall, 1.2 percent in the $500,000 band, 2.6 percent from $1 million to $5 million and 9.5 percent above $10 million.

The band matters more than the exchange, and a completed exchange keeps you out of the higher bands. Deferred gain is not total positive income; it sits on Form 8824 line 24 and never becomes income. A failed or heavily partial exchange is the version that lifts a seller two or three bands in a single year.

Returns are picked by score and by relationship, not by which form is attached

The IRS describes its methods plainly on its audits page: random selection and computer screening against statistical norms, and related examinations, where your return is pulled because a partner, an investor or a business associate is already under examination. It also states that “selection for an audit does not always suggest there's a problem.”

Contact comes by mail; the IRS says it does not start an examination by telephone. The letter contains a written request naming the documents wanted.

The lookback is generally three years of returns, and the IRS says it may add years where substantial errors are found, usually not going beyond six. For a chain of exchanges that is the important asymmetry: the return can be closed while the basis it created stays open to challenge on a later sale.

The four answers on a return that a 1031 makes an examiner read twice

None of these is an audit trigger in any published IRS document, but each is a disclosure the exchange itself forces you to make, and each has a factual test behind it that only records can answer.

• Form 8824, Part II. Answering line 7 “Yes” opens the related-party questions, and the note on the front of the form tells you not to file at all where a related party sold into the exchange and no exception applies — see who counts as a related party.
• Form 1065, Schedule B, line 11. Partnerships check a box if, in the current or a prior tax year, they distributed property received in a like-kind exchange or contributed such property to another entity; line 12 asks whether any partner received a tenancy-in-common interest. Those are the two drop-and-swap disclosures — see drop-and-swap strategies.
• A replacement that becomes a residence. Rev. Proc. 2008-16 sets the only safe harbour, and a Schedule E that stops mid-year invites the question — see renting the replacement before moving in.
• A Schedule E with no rent and no depreciation for the replacement in its first full year, which is the fact pattern the Tax Court examined in the intent cases.

Build the file around the four things the statute makes you prove

Each document below answers a specific requirement, which is why a generic “keep everything” list is less useful than a mapped one. Ask your own CPA or attorney how these retention rules apply to your entity and your state filings.

• Exchange agreement including the clause that strips you of any right to the funds before the exchange period ends — Reg. §1.1031(k)-1(g)(6).
• Written assignments of the purchase and sale contracts to the intermediary, plus the written notices to the buyer and the seller — Reg. §1.1031(k)-1(g)(4)(v) requires all parties to be notified on or before the transfer.
• The identification letter, signed and dated, with the fax confirmation, courier receipt or email header — Reg. §1.1031(k)-1(c)(2) requires a signed written document sent before the period ends.
• Both settlement statements, which supply Form 8824 lines 15, 16 and 18, and the intermediary's account statement and wire records.
• Leases, rent ledgers, listing agreements and the Schedule E for every year, proving the held-for-investment requirement in §1031(a)(1).
• A day count of rental days at fair rental and personal-use days if the property is a dwelling unit, matching the Rev. Proc. 2008-16 standard.
• The depreciation schedule showing carryover basis from Form 8824 line 25 forward — the single record most often lost between preparers.

Three years from filing is the wrong clock for exchange records

The IRS's record retention guidance sets three years as the base, six years where income that should have been reported is understated by more than 25 percent of gross income, and no limit where a return is fraudulent or never filed.

For property it says something different and far more demanding: keep records relating to property until the period of limitations expires for the year in which you dispose of the property, and where a nontaxable exchange is involved, keep the records for both the old and the new property.

So the exchange file from a 2012 sale is still live in 2026 if you still own the replacement, because it is the only evidence of the basis you are depreciating. Chain three exchanges and the first file supports the third property's basis — the arithmetic is set out in calculating basis after a 1031.

If a letter does arrive, the file answers the questions in order

An examiner working a section 1031 issue has a short list: was there an exchange rather than a sale, were the deadlines met, did you have control of the proceeds, and were both properties held for investment. The documents above line up one to one against that list, which is why assembling them now costs an hour and assembling them in year four often cannot be done.

Where an entity is involved, the same-taxpayer question comes first, and the evidence is the operating agreement and the deeds rather than the exchange file — see same-taxpayer rules.

We are a 1031 exchange broker, not an accountant, and we do not represent taxpayers before the IRS. Where part of an exchange goes into a Delaware Statutory Trust, what we can do is make sure the sponsor closing statement, subscription documents and annual reporting reach your file in a form your preparer can use.