With the numerous tax benefits that come with doing a 1031 exchange, there has been considerable abuse over the years by investors who have used various “related party” strategies or techniques to defer, avoid and even evade the payment of their income tax liabilities.
Over the last decade, 1031 Exchanges have certainly not been immune to such tax abuse, and the Internal Revenue Service (“IRS”) has issued rules and guidelines on related party 1031 Exchange transactions to mitigate such investor abuse.
Thinking of doing a 1031 exchanging into a Delaware Statutory Trust? Contact us today at Sera Capital for proper guidance.
Who is Considered a Related Party in a 1031 Exchange?
The term “related person” or “related party” means any person or party, including entities, that has a relationship to the taxpayer described in Section 267(b) or Section 707(b)(1) of the Internal Revenue Code (IRC), including:
- Members of the same family (siblings, spouse, ancestors, and lineal descendants)
- Corporation where more than 50 percent of the value of the stock is owned directly or indirectly by or for one individual
- Two (2) corporations that are in the same controlled group (as defined in subsection (f))
- A grantor and a fiduciary of any trust
- A fiduciary of one trust and the fiduciary and/or beneficiary of another trust where the same person is the grantor for both trusts
- A fiduciary of a trust and a beneficiary of the same trust
- Corporation where more than 50 percent of the value of the stock is owned directly or indirectly by or for one particular trust or by or for the grantor or fiduciary of the trust
- An organization qualified under Section 501 of the Internal Revenue Code (relating to certain educational or charitable non-profit organizations) which is controlled directly or indirectly by a specific person or, if such person is an individual, by members of the family of such individual
- A corporation and a partnership if the same person or persons own:
- More than 50 percent in value of the outstanding stock of the corporation, and
- More than 50 percent of the capital interest, or the profits interest, in the partnership
- An S corporation and another S corporation or a C corporation if the same person or persons own more than 50 percent in value of the outstanding stock of each corporation
- A partnership and a person owning, directly or indirectly, more than a 50-percent capital interest or a 50-percent profits interest, in such partnership
- Two partnerships in which the same person or persons own, directly or indirectly, more than a 50-percent capital interest or a 50-percent profits interest, in both partnerships
- An executor of an estate and the beneficiaries of the estate.
A testamentary trust created by a husband and an inter vivos generation skipping trust created by a wife are not related persons because the trusts did not have the same grantor per Private Letter Ruling 9224008. Investors may be able to eliminate related party transaction issues by changing the ownership of the related party, such as transferring or disposing of interests in a partnership or shares in a corporation to an unrelated third-party, in order to get the related party’s ownership interest below the 50-percent level.
Understanding IRS 1031 Exchange Related Party Rules
Initially, related parties could do a 1031 exchange without any additional conditions. In 1989, the IRS recognized this loophole and added an anti-abuse provision: IRC Section 1031(f) — Special Rules for Exchanges Between Related Persons.
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 property. 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).
Section 1031 (f) or 1031 exchange related party rules covered four major aspects: Swapping with a related party, selling to a related party, buying from a related party, and several exceptions to the rules.
- 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.
- 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 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.
- Buying from a related party
The IRS has clarified that 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. The exchange likely will be respected even if the related buyer voluntarily disposes of the property it acquired from the taxpayer within two years of acquisition.
The rationale behind the idea was that only the taxpayer owned property before the exchange and the taxpayer continued to be invested 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.
Are there any other exceptions to Related Party Rules?
As indicated above, the two-year holding period exception has limited applicability, applying only to exchanges between taxpayers who receive (and hold) each other’s property. Under this exception, if the properties are held for a minimum of two years, there is a presumption that the trade was motivated by reasons other than “abusive basis shifting.”
Another exception, under Section §1031(f)(2)(C), provides for an earlier than two year disposition of a property that is part of a related party transaction. This section states that the transaction will not be disqualified if, “with respect to which it is established to the satisfaction of the [Treasury] Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.” Most exchanges involve tax deferral, so it is difficult to make this case. There have, however, been favorable IRS rulings in which family members exchanged undivided interests in several properties in order to allow each to own a whole. This is a perfect example of this exception.
An additional exception is based upon a series of private letter revenue rulings beginning with PLR 201220012 which pertained to a taxpayer’s disposal of replacement property within the two-year period. The ruling concluded that since the related party did an exchange from that property into another, there was no cashing out and therefore no tax abuse.
Finally, a rarely used exception to the requirement of both parties retaining the property for two years or more occurs in the event of the death of the taxpayer or the related person. Such an event will allow for the exchanged property being sold within the two-year period while maintaining the original deferral.
IRS Form 8824, Like-Kind Exchanges, must be filed when a 1031 Exchange involving like-kind property occurs. When related parties exchange property, additional information is required, including the name, address, taxpayer identification number or social security number, and relationship of the related party.
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. These are some of the exceptions and it is important that you discuss the exchange with your tax advisor.
Need help with doing a 1031 exchanging into a Delaware Statutory Trust? Contact us today at Sera Capital for proper guidance.