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What is a related party exchange?
A related party exchange is a 1031 exchange where either the buyer of the relinquished property or the seller of the replacement property (or both) is considered "related" to the investor doing the exchange. If either the buyer of the relinquished property or the seller of the replacement property is considered a related party, there are special rules and restrictions on the ability to defer tax in a 1031 exchange.
What is a related party?
"Related party" has a special meaning in tax law. For Section 1031 purposes, a related party includes certain family members, such as spouses, brothers, sisters, ancestors (such as parents and grandparents) and lineal descendants (such as children and grandchildren). Related parties also include, for example, a corporation or partnership and a person who owns more than a 50% interest in the corporation or partnership. Other parties can be considered related parties. For a thorough list, see Internal Revenue Code Sections 267(b) and 707(b)(1).
How are related party exchanges reported to the IRS?
One of the first questions a taxpayer must answer on IRS Form 8824, which is the form used to report exchanges, is whether the exchange was done, directly or indirectly, with a related party.
Can I do an exchange with a related party?
The answer to this question depends on several factors. First, are you swapping properties with the related party, transferring your relinquished property to the related party, or acquiring your replacement property from the related party? These three situations are analyzed separately below.
"Swapping" with a related party
It is not common, but occasionally an investor wants to simply swap properties with another investor. In other words, the investor transfers the relinquished property to the other party and in exchange, the other party transfers the replacement property to the investor. Both parties are doing an exchange and no third party buyers or sellers are involved. When swapping with a related party, both the investor and the related party must hold their respective replacement properties for a period of at least two years after the last transfer occurs in the exchange. If either party transfers the property before the expiration of the two year holding period, both parties' exchanges will be disqualified.
"Selling" to a related party
Much more frequently, the investor is using a qualified intermediary and wants to sell the relinquished property to a related party and acquire replacement property from an unrelated party. Selling to a related party is acceptable, as long as the investor holds the replacement property acquired in the exchange for at least two years, and the related party holds the relinquished property for at least two years. If either party transfers the property that party owns before a period of two years after the last transfer in the exchange occurs, the investor's exchange is disqualified.
Some investors have attempted to argue that using a qualified intermediary will eliminate the related party problem. The argument is that the qualified intermediary is really the buyer of the relinquished property, not the related party. That rationale appears to be have gained some ground in the form of a recent private letter ruling (PLR 200709036) in which a deferred exchange facilitated by a qualified intermediary whereby relinquished property was sold to a related party (who planned to sell the property within two years) was held not to be a related party transaction that would trigger the two-year rule.
In light of the fact that a private letter ruling is not precedent and cannot be relied upon by anyone other than the taxpayer obtaining the ruling, it is important to address the related party rules even when the investor is using a qualified intermediary in connection with the exchange.
"Buying" from a related party
If an investor wants to buy the replacement property from a related party (through a qualified intermediary as part of an exchange transaction so that the investor can sell the relinquished property to an unrelated third party), it is far less likely that the exchange will result in the deferral of tax. During the last several years, the IRS has issued several rulings which have disqualified exchanges when the investor was buying replacement property from a related party.
The IRS looks at the related party and the investor as one economic unit, and does not like to see the investor get tax deferral and the related party get cash. When the investor acquires replacement property from a related party and sells relinquished property to an unrelated party, that is exactly what happens - i.e., the investor gets tax deferral and the related party gets cash.
There is one exception to this general rule that has been approved in two private letter rulings (PLR 200440002 and PLR 200616005). In these rulings, the investors acquired replacement properties from related parties, and the related parties were also doing tax-deferred exchanges. Both parties to each exchange stipulated that they would hold their replacement properties for at least two years. In both rulings, the IRS held that the investor's exchange was valid, since there was no "cashing out" by the related party. However, in the second ruling, the IRS upheld the exchange, despite the fact that at the end of the exchange the investor received cash in addition to his replacement property.
Are there any other exceptions to the two year holding period?
There are three exceptions to the requirement that the related party and the investor hold the properties acquired in the exchange for at least two years after the last transfer occurs in the exchange. A disposition within the two year period will not cause an exchange to fail if it occurs (1) after the death of either the investor or the related party, (2) due to a condemnation, provided that the condemnation was not threatened or imminent before the exchange occurred, or (3) under such circumstances that it is established to the satisfaction of the IRS that neither the exchange nor the subsequent transfer had as one of its primary purposes the avoidance of federal income tax.
The first two exceptions mentioned above are very specific and unusual. The final exception is much more general and less clear. According to some legislative history, this exception may cover exchanges of undivided interests in different properties which result in each related party owning the entire interest in one property or a larger interest in any one of the properties (for example, when there is a partition action), dispositions of properties in "non-recognition transactions" (for example, when the related party is also doing an exchange), and transactions which do not involve the shifting of basis (for example, if the related party's basis is as low or lower than the basis of the investor who is doing the exchange).
What should I do?
Before doing a related party exchange, particularly when planning to acquire replacement property from a related party, it is important to discuss the exchange with your tax advisor. If you plan to sell the relinquished property to the related party or swap properties with the related party, you should consider getting a written commitment from the related party that he will hold the property he has acquired for at least two years. The two year period starts as of the date of the last transfer in the exchange, which can occur as late as 180 days after the first relinquished property closes.
References; Internal Revenue Code Section 1031(f), Revenue Ruling 2002-83, PLRs 200440002, 200616005 and 200709036 and Teruya Brothers, Ltd & Subsidiaries v. Comm., 124 T.C. No. 4 (2005).
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All information contained herein is provided as a matter of courtesy to our clients. First American Exchange Company, its officers and agents make no representations as to the completeness and applicability of the information contained herein to each individual taxpayer. As a Qualified Intermediary, First American Exchange Company is precluded from providing tax or legal advice to its clients. Please consult your own independent tax or legal advisor regarding your specific circumstances.
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