Receipt of Non-Like-Kind Property is Not Fatal to a Related Party Exchange

Exchanges that involve related parties are subject to special rules.  Related parties may include: members of the same family (including spouses, ancestors & lineal descendants); an individual and a corporation or partnership, if the individual owns more than 50% of the entity; or a fiduciary and a grantor or a beneficiary of the same trust.1 


The IRS is concerned that related parties might use a tax-deferred exchange to engage in abusive basis shifting, as outlined in the legislative history:


Because a like-kind exchange results in the substitution of the basis of the exchanged property for the property received, related parties have engaged in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property in order to reduce or avoid the recognition of gain on the subsequent sale. Basis shifting can also be used to accelerate a loss on retained property. The committee believes that if 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 non-recognition treatment.2

To curb these abuses, there is a mandatory two-year holding period for exchanges between related parties.  


Cashing Out


But what does it mean to “cash out”?  What if one of the related parties receives some non-like-kind property in the exchange, but all of the other statutory requirements have been met?  Will the IRS accept a “no harm, no foul” rule for a nominal disposition of non-like-kind property?


A recent Private Letter Ruling4 involved a series of transactions between related parties where each transaction in the series otherwise qualified as a like-kind exchange under §1031(a), and none of the related parties received more than a minimal amount of non-like-kind property in their transactions.5


The Taxpayer’s Exchange


The Taxpayer is a corporation that elected to be taxed as a real estate investment trust (REIT).  The Taxpayer owned and operated a commercial real estate project through various entities that were disregarded for federal income tax purposes.6


The Taxpayer is an affiliate of Parent, which is also a REIT.  The Parent owns 92% of Operating Partnership (OP).  The Parent owns various properties through OP and other subsidiary entities.  OP owns 100% of the membership interest in LLC#3, which owns 99.9% of the stock of Taxpayer.  RP#2 LLC is a subsidiary of OP.


The Relinquished Property (RQ) is improved real property.  The Taxpayer owns (RQ) through a series of disregarded entities.  The Taxpayer’s exchange involved a reverse exchange of RQ and the acquisition of two replacement properties.  RP#2 was owned by a disregarded subsidiary of OP (a related party to Taxpayer).  The related party issue arises only in connection with the acquisition of RP#2.


The OP Exchange


OP entered into a deferred exchange agreement with a QI to engage in its own like-kind exchange.  Taxpayer’s RP#2 also constituted OP’s relinquished property (OPRQ). OP identified three potential replacement properties, including properties held by unrelated third parties and by entities related to OP (Affiliates).


OP intends to acquire replacement properties for an amount equal to the sale price of OPRQ less transaction costs. However, if OP acquires replacement property having a value less than 100% of the value of OPRQ, OP will receive non-like-kind replacement property to the extent of the difference and recognize gain in the full amount of such difference. The amount of non-like-kind property that OP will receive in its §1031 exchange will not exceed 5% of the gain realized by OP on its transfer of OPRQ.


Affiliate Exchanges


If any OP replacement property is owned by an Affiliate (Affiliate RQ), the Affiliate will enter into a deferred exchange for such properties.  As noted above with respect to OP’s exchange, Affiliate may acquire replacement property having a value less than that of the applicable Affiliate RQ.  In that event Affiliate will receive non-like-kind property, not to exceed 5% of the gain realized by the Affiliate on its transfer of the Affiliate RQ.


IRS Ruling


The Taxpayer represented that Taxpayer, OP and Affiliates will hold their replacement properties for at least two years after the date of the last transfer of property in the series of exchanges.  So on its face, the related party rule seems satisfied.


However, there is a “catch-all” provision7 which provides that §1031 does not apply to any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the related party rules.  Thus if the Taxpayer is structuring these transactions with tax avoidance as one of its principal purposes, using a Qualified Intermediary or Exchange Accommodation Titleholder to disguise its motives, §1031 will not apply.8


In this case, the related parties disposed (or cashed out) of their investment to the extent that they received non-like-kind property.  There is nothing in the Internal Revenue Code or accompanying regulations that establish a de minimis exception for the amount of any such disposition.


The Taxpayer was able to find recourse in §1031(f)(2)(C), which provides that a disposition is not taken into account if it can be established to the satisfaction of the IRS that neither the exchange nor the disposition had the avoidance of federal income tax as one of its principal purposes.


The IRS found that since both OP and any transferring Affiliate will also structure their disposition of property as an exchange for like-kind replacement property, neither §1031(f)(1) nor (f)(4) apply to trigger gain recognition in Taxpayer’s exchanges or to disqualify the application of § 1031 to this series of exchanges.  Upon completion of the series of transactions, all related parties will own property that is of like-kind to the properties exchanged for at least two years after the date of the last transfer in the series.


Furthermore, the IRS found that there is no “material cashing out” by any of the related parties within 2 years of the last transfer in the series of transactions because neither Taxpayer, OP nor an Affiliate will receive non-like-kind replacement property greater than 5% of the gain realized on its disposition of relinquished property.




This ruling seems to confirm the concept that there can be some disposition of non-like-kind property, as long as there is no “material cashing out”.  Unfortunately, there is no discussion of how much cashing out is allowed before it reaches the level of being “material”.  Until further guidance is issued, the conservative approach suggests limiting any cash out to the 5% figure approved in this ruling.


Related party transactions raise many issues not discussed in this article.  For a more complete overview of the related party rules, please click on this link to see the article first printed in our April, 2011 newsletter.  Please contact your local First American Exchange office if you have any questions regarding your next exchange transaction.




1.  26 USC 267(b).

2.  H.R. Rep. No. 386, 101st Cong., 1st Sess. 614 (1989).

3.  26 USC 1031(f)(1).

4.  PLR 201216007 (April 20, 2012).

5.  Rev. Proc. 2011-1; A private letter ruling, or PLR, is a written statement issued to a taxpayer that interprets and applies tax laws to the taxpayer’s represented set of facts.  A PLR is issued in response to a written request submitted by a taxpayer.  A PLR may not be relied on as precedent by other taxpayers or by IRS personnel.

6.  All of the LLC’s referred to in this article are entities which are disregarded for federal income tax purposes.

7.  §1031(f)(4).

8.  See, e.g., Teruya Brothers Ltd. v. Commissioner, 580 F.3d 1038 (9th Cir. 2009); Ocmulgee Fields v. Commissioner, 613 F.3d1360 (11th Cir. 2010); and Rev. Rul. 2002-83, 2002-2 C.B. 927.


Have additional questions for us?  Ask your question here.  Want to get started with your exchange?  Start yours here.

Stay up to date on the 1031 exchange industry, sign up for updates here.