Related Party 1031 Exchanges

The Internal Revenue Service covers the issue of related party exchanges under IRS Section 1031(f). While such exchanges are permitted, an exchanger must follow specific rules and guidelines for the exchange to qualify. The IRS has always been concerned about related parties exchanging low-basis property for high-basis property to avoid capital gains taxes. A series of rulings and anti-abuse provisions, including Revenue Ruling 2002-83, outline the IRS’s position, allowing advisors to better strategize with clients interested in pursuing such transactions.

Determining Who Is a Related Party

The definition of a related party in a real estate transaction is covered under two areas of the Internal Revenue Code, Sections 707(b) and 267(b). The IRS definition extends to individuals and business entities:

• Immediate family members — spouses, siblings, ancestors, and lineal descendants;
• A grantor and fiduciary of a trust;
• An estate’s executor is a related party to the estate’s beneficiaries;
• Individuals, corporations, LLCS or partnerships where more than 50% of the stock, membership interest, or partnership interest, whether such common ownership is either direct or indirect, is owned by the taxpayer;
• Two corporations if they are members of the same controlled group.

This list is not exhaustive. Taxpayers in doubt over what constitutes a related party should consult both their tax advisors and the relevant sections of the Internal Revenue Code.

The History of Related Party Exchanges

In the absence of regulatory guidelines, many taxpayers frequently exploited loopholes in the IRC by exchanging low-basis property for high-basis property and then cashing out the low-basis property. In the industry, this practice came to be known as “basis shifting.”

Example: Two sisters, Ellen and Joan, each own investment property. Ellen’s property is a low-basis apartment building with a fmv of $100,000 and an adjusted basis of $50,000. Joan’s is a warehouse with a fmv of $100,000 and an adjusted basis of $100,000. Ellen wishes to liquidate the asset with the low basis but knows that doing so will trigger capital gains tax.

Before the IRS imposed limits on related party exchanges, the siblings could swap properties. Joan’s pre-exchange basis in the warehouse would transfer to the apartment building. Joan could then sell the apartment to an unrelated party without paying any capital gains tax.

Section 1031(f): The Two Year Holding Requirement

In 1989, the IRS enacted Section 1031(f). Speaking to the practice of basis shifting: “[I]f a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, ‘cashed out’ of the investment, and the original exchange should not be accorded nonrecognition treatment.”

This provision provides that properties exchanged by related parties can’t be sold for two years following the exchange. The two-year holding period starts on the date of transfer or conveyance of the last property involved in the 1031 and affects both related parties. While the ruling does not end the practice of basis shifting, it places serious restrictions on it.

There are several exceptions to the two year holding requirement:
• The related party from whom the replacement property was acquired defers his/her own tax by structuring and completing his/her own 1031 exchange;
• The transfer occurs after the death of the taxpayer or the death of the related party;
• The related parties own fractional interests in multiple properties and structure a 1031 exchange so that each party ends up owning 100% of one of the properties;
• The disposition occurs due to an involuntary conversion pursuant to IRC Section 1033;
• You can prove that tax avoidance was not the purpose of the transfer of property.

Related Party Seller

The IRS initially made no distinction between selling or buying properties pursuant to a related party exchange. However in 1997, the IRS released Tax Advisory Memorandum 9748006, which essentially prohibited taxpayers from buying replacement property from a related party. Since that time, most 1031 exchanges in which the replacement property seller is the related party have not qualified for tax deferral unless the related party seller also does a 1031 exchange. Revenue Ruling 2002-83 further provides that an exchange will fail where a taxpayer acquires replacement property from a related party that receives cash or other non like kind property regardless of whether the taxpayer holds the replacement property for the requisite two years.

The IRS has again noted in a series of transactions that a taxpayer can initiate a valid exchange by purchasing property from a related party as long as the seller completes his/her own 1031 exchange as well. The IRS upheld such exchanges on the grounds that neither party cashed out their investments and continued holding their respective replacement properties for two years after the exchange. PLRs 200440002 and 200616005. The IRS has also issued several additional rulings where the taxpayer acquired replacement property from a related seller who then also acquired replacement property from another related seller as long as the last related seller exchanged into replacement property from an unrelated seller to complete the last line of exchanges and where all replacement properties were held for at least two years. The IRS ruled that a small amount of boot (5% or less) received by any of the sellers would not destroy the integrity of the exchanges. PLRs 201220012, 21216007, 201048025, 200820025 and 200820017.

Related Party Buyer

The IRS has maintained there is no basis shifting or tax avoidance when the taxpayer, through an unrelated Qualified Intermediary, transfers relinquished property to a related buyer, but acquires replacement property from an unrelated seller. While there is some authority that the exchange would be respected regardless of whether the two year holding requirement was satisfied, both the related party and the taxpayer are still encouraged to hold their respective properties for two years to ensure qualification under section 1031. The Service’s rationale has been that the taxpayer is the only one owning property before the exchange and the taxpayer continues to invest in like-kind property following the exchange. Because the related buyer did not own property prior to the exchange, its subsequent disposal would not result in cashing out or basis-shifting by the taxpayer. PLRs 200709036, 200712013, 200728008, 201027036.

Avoidance of Federal Income Tax

Under IRC §1031(f)(2)(C) and (f)(4), a related party exchange will be disallowed if it is part of a transaction (or series of transactions) structured to avoid payment of Federal income tax or the purposes of the related party rules. In determining whether these sections apply, the IRS tends to look at the overall tax result of the transactions to the related parties as a consolidated unit. Even if there is no basis shifting, an exchange in which replacement property is purchased from a related party seller (that does not also do an exchange) will be disallowed if the related seller ultimately pays less tax on the sale of the replacement property than the Exchanger would have paid on the sale of its relinquished property, due to factors such as net operating losses or lower tax rates available to the related seller. Ocmulgee Fields, Inc. v. CIR, 132 T.C. No 6 aff’d 613 F.3d 1360 (11th Cir. 2010), Teruya Brothers, Ltd. V. CIR, 124 T.C. No. 4, aff’d 580 F.3d 1038 (9th Cir. 2009), PLR 201013038. Conversely, the IRS has upheld exchanges where it could be demonstrated that there was no basis shifting and that avoidance of federal income tax was not a principal purpose of the transaction, notwithstanding that the taxpayer and related parties swapped properties, and then the related buyer voluntarily disposed of the property it had acquired from the taxpayer shortly after the exchange. PLRs 200706001 and 200730002.

Summary and Analysis

As noted above, the opportunity for tax deferral clearly applies to related party transactions if properly structured in accordance with the IRS rules and guidelines. Consulting a tax professional is strongly recommended to ensure a smooth transition.