If you are contemplating doing an exchange with a party or entity related to you, it’s important to understand the additional rules involved. In some cases you may not be able to do an exchange and in other cases you may have to hold your replacement property for a two year holding period. This article explains the basics of what you can do and why these rules exist.
What is a related party exchange?
A related party exchange occurs when the taxpayer does a 1031 exchange with a party or entity that is considered related to the taxpayer under the tax code. “Related party” is defined in Sections 267(b) and 707(b) of the Internal Revenue Code. For individuals, related parties include your spouse, brothers, sisters, ancestors and lineal descendants. If you own more than a 50% interest in a corporation or partnership, you and the corporation or partnership are related parties. There are many other examples of what is related in the tax code, so to determine whether you are related, check Sections 267(b) and 707(b).
Initially, related parties could do a 1031 exchange without any additional conditions. In 1989, Section 1031 of the Internal Revenue Code was revised to limit related party exchanges. The reason for the change was to discourage “basis shifting” where a taxpayer with a low basis trades properties with a related taxpayer with a high basis. This is done to eliminate or reduce capital gains taxes on the sale of the property that originally had a low basis (and now in the hands of the related party, has a high basis).
Can I exchange with a related party?
The answer to this question depends on what you want to do. Are you swapping with a related party? Are you using a qualified intermediary and either selling to or buying from a related party?
Swapping with a related party
If you are swapping with a related party such that you are relinquishing property to that party and acquiring replacement property from the related party, you can do an exchange provided that both the related party and you hold the properties acquired in the exchange for a minimum of two years after the date of the last transfer that was part of the exchange. If you or the related party transfers the property before that date, both exchanges will be disqualified. Both of you will need to pay tax on the gain. That tax will be payable for the tax year in which the sale of the property acquired in the exchange occurs.
There are a few exceptions to the rule that related parties must hold their properties acquired in the exchange for two years. These exceptions are discussed later in this article.
Selling to a related party
In the past, some people have tried to avoid the related party restrictions by setting up their exchange with an intermediary. The theory was that the intermediary was actually exchanging with the taxpayer and therefore it was not a related party exchange. There have been several cases and rulings, however, that have held that using an intermediary doesn’t remove the related party restrictions, due to Internal Revenue Code Section 1031(f)(4) which says that the benefits of Section 1031 don’t apply “to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.”
You should be able to do an exchange using an intermediary when you are selling to a related party and buying from an unrelated party. The traditional advice, based on Section 1031(f), is that both you and the related party should hold the property acquired for a minimum of two years after the exchange. The exceptions to the requirement to hold the properties for two years, discussed below, have resulted in some rulings that have permitted taxpayers to sell to a related party with the understanding that the related party could dispose of that property before the end of the two year period. Since these exceptions were in private letter rulings rather than published cases, you should discuss this issue with your tax advisor before cutting short the two year holding period.
Buying from a related party
If you are using an intermediary, buying from a related party and selling to an unrelated party, there are very limited instances where you can use a 1031 exchange to defer gain. In most cases, the IRS and courts have disqualified those exchanges because of the potential for basis shifting. The basis shifting can occur and ruin the exchange even when it is unintentional.
There have been some rulings which have allowed a taxpayer to buy from a related party provided that the related party was also doing an exchange. In these cases, the related party was buying replacement property in their exchange from an unrelated party. In addition, the rulings have permitted these taxpayers to take boot in an amount up to 5% of the amount of the gain.
As discussed above, the related party rules impose a two-year holding period for properties acquired in an exchange, and in some cases prohibit exchanging with a related party. Section 1031(f)(2) contains three exceptions to the limits imposed by 1031(f)(1). First, the parties may dispose of their properties during the two-year holding period upon the death of either the taxpayer or the related party. Second, if either party’s property is subject to an involuntary conversion prior to the end of the two-year period, that disposition will not trigger a taxable event for the parties. Finally, trading with a related party will not disqualify the exchange when “it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.”
This last exception (the “non-tax avoidance exception”) has been used to allow related parties with undivided interests in different properties to trade them so that each taxpayer holds either a 100% interest in one of the properties or a larger undivided interest in one of the properties. For example, if two related parties each owns a 50% tenant-in-common interest in two properties, they can trade their interests such that each taxpayer owns a 100% interest in one of the properties. There is a ruling which allowed the parties to dispose of one of the properties after this exchange and before the end of the two year period without triggering capital gains tax for the other party.
As mentioned above, the non-tax avoidance exception has also been applied to exchanges where the taxpayer is acquiring replacement property from a related party who is also doing an exchange. Finally, the non-tax avoidance exception has been applied to transactions that don’t involve basis shifting or other avoidance of tax, but rulings on this that are favorable to the taxpayer have been very limited.
Taxpayers who are swapping with or selling to a related party should be able to structure a valid exchange as long as both the taxpayer and the related party hold the properties acquired in the exchange for a period of at least two years after the last transfer in the exchange. Taxpayers who are buying from a related party will generally find that their exchanges are disqualified. There are some exceptions and it is important to discuss the exchange with your tax advisor.
Internal Revenue Code Section 1031(f); Revenue Ruling 2002-83; Teruya Brothers, Ltd. & Subsidiaries v. Comm., 124 T.C. No. 4 (2005); PLR 200712013; PLR 201216007.
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