A 1031 Exchange is a great tool for selling and buying a home. It helps avoid capital gains on proceeds and limits the immediate tax liability of the seller. The common notion is a 1031 Exchange "exempts" a seller from any payment of tax and thus reporting is not necessary.

However, an exchange really only defers the taxes owed. Per the IRS, "Gain deferred in a like–kind exchange under IRC Section 1031 is tax–deferred, but it is not tax–free." More importantly for a settlement agent, an exchange transaction is not exempt from IRS reporting. A 1099–S must still be filed, reporting the transfer to the IRS.

In order to report the transfer be sure to have the seller complete the Substitute 1099–S form. The seller should mark the "Exchange" box and enter "$0" for the gross proceeds unless the seller is receiving "boot."

A "boot" occurs when a seller receives part of the proceeds from the relinquished property and does not reinvest in the exchange to purchase the replacement property. The seller should reflect the amount of "boot" in the gross proceeds box while still checking the exchange box.

Reporting a sale to the IRS only alerts the IRS a transfer occurred. Whether taxes are due or not due is between the seller and the IRS when the seller files their tax return. Failing to report a non–exempt sale is subject to an IRS penalty of up to $10,000 per instance for intentional disregard.