November Edition
As a Qualified Intermediary we are often asked if it’s OK to buy or sell a property with a relative or related entity in a §1031 Exchange. A Tax Court Ruling supports the IRS’s position that exchanging with a related party is not allowed when an exchanger is selling to an unrelated party, using a Qualified Intermediary to facilitate the exchange and purchasing from a related party.
The IRS has a clear definition of related parties as any person or entity having a relationship with the exchanger, such as members of a family (siblings, half-siblings, spouse, ancestors, grandchildren, lineal descendants); two corporations that are members of the same controlled group; a grantor and fiduciary of any trust; partnerships and corporations with more than 50% ownership in value of the outstanding stock, capital interest, or profits of the partnership or corporation.
When related parties are exchanging or “swapping” properties with each other, a §1031 Exchange is permitted as long as both parties hold their respective replacement properties for two years. If either party disposes of their property prior to the two-year holding period, the exchange fails for both parties and any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs.
Oftentimes, a taxpayer desires to sell property to a related party then purchase their replacement property from an unrelated entity. This type of transaction is allowed and is not perceived to be a “related party exchange.” In these types of transactions most accountants and exchange professionals recommend that the related party holds the property for two years as IRS Form 8824 Instructions indicate that the two-year holding rule applies. Several Private Letter Rulings indicate that the two year holding rule does not apply when an exchanger sells to a related party (see PLR 200706001, PLR 200712013 & PLR 200728008). It’s important to note that Private Letter Rulings are written for specific taxpayers and while they are not controlling authority, they do help taxpayers to understand the intent behind IRS positions.
The two-year holding rule was imposed to prevent taxpayers from doing a so called “basis shift,” substituting a low basis property for a high basis property with the intended purpose of avoiding taxes. Prior to the inclusion of the Related Party rules in IRC §1031, exchangers who wanted to sell a low basis property to an unrelated party would first exchange with a relative who had a high basis property. Now relative’s high basis becomes basis of property that unrelated party wants. Relative sells with minimal tax consequences and relatives share in profit. Purchasing from a related party is not allowed if the taxpayer is doing a so called “basis shift” or if the related party receives cash (Revenue Ruling 2002-83). In these types of transactions, the IRS takes the position that if the taxpayer or a related party “cashes out” of property the exchange is disallowed.
For example, let’s assume Taxpayer Joe is selling his investment property for $1M and that he has a $100k basis. He desires to sell to an unrelated party and purchase a $1M replacement property from his son who has a $900k basis in his property. When Taxpayer Joe sells, his basis does not transfer to the buyer, it remains with Joe. Meanwhile, Joe identifies and purchases his son’s property as his §1031 replacement property. In this example Joe pays no taxes and his son is paying tax only on the $100k gain. The IRS will likely consider this a related party basis shift and fail the exchange. If Joe’s son was also doing an exchange or the two parties were swapping deeds the exchange would work as no one would be cashing out.
The Tax Court has recently confirmed that a taxpayer cannot avoid the related-party rules by simply using a Qualified Intermediary. The court held that transactions involved were economically equivalent to direct exchanges of properties between the related parties, followed by the sale of property by one of the related parties to unrelated third parties. The involvement of a Qualified Intermediary couldn’t obscure the end result. The Tax Court agreed with IRS that the transactions violated the IRC §1031(f)(4) Related Party rules.
When considering an exchange with a related party it’s important to be mindful of the two-year holding rule and the likelihood of a basis shift. It’s always a good idea to consult with a tax or legal professional that has all of the facts and circumstances relative to an exchanger’s current status.
