Related Party Exchanges: Caution Needed in These Transactions

INTENT OF THE RELATED PARTY RULES

The related party rules were enacted to prevent related parties from “cashing out” of an investment and avoiding tax if either party’s property is disposed of within two years of the exchange. In addition, Section 1031(f) states that the Internal Revenue Service reserves the right to invalidate any exchange in which the taxpayer can’t prove that the “exchange” did not have a principal purpose of avoiding taxes that would otherwise be due or avoiding the purposes of the related party rules.

 

WHO IS A RELATED PARTY?

A related party is any person or entity bearing a relationship with the taxpayer. Although not an exhaustive definition, this includes:

  • Family members such as brothers, sisters, spouses, ancestors and lineal descendents. (Stepparents, uncles, in-laws, cousins, nephews and ex-spouses are not considered related.)
  • A corporation or partnership in which more than 50% of the stock or more than 50% of the capital interest is owned by the taxpayer.

LET’S LOOK AT SEVERAL SCENARIOS

Although it is important to consult with tax or legal advisors before attempting any exchange with a related party, some guidelines exist which are useful in analyzing related party exchanges.

Simultaneous Exchange

When related parties directly swap with each other both parties must hold the property acquired for two years following the exchange. If either party disposed of their property within the two year holding period, then the capital gain tax will need to be recognized.

Delayed-Selling to a Related Party

A tax-payer can sell to a related party, but the related party must hold the property for a minimum of two years or the exchange will be invalidated.

Delayed-Purchasing from a Related Party

In Private Revenue Ruling 9748006, the IRS disallowed tax deferral to an Exchanger who purchased his mother’s property. Revenue Ruling 2002-83 also denied tax deferred treatment to an Exchanger using a Qualified Intermediary to ultimately purchase a replacement property from a related party. A conservative guideline to observe is: “if the buyer and seller are related, and one of the parties ends up with the property and the other ends up with the cash, the exchange will probably be disallowed.”

 

SECTION 1031(f)

Section 1031(f)(4) of the Code adds special rules for transactions between related persons. For purposes of Section 1031(f), the term “related person” means any person bearing a relationship to the Exchanger described in Section 267(b) or 707(b)(1).

Essentially, Section 1031(f) denies tax deferral when related parties perform an exchange of low basis property for high basis property in anticipation of the sale of the high basis property. The rationale for Section 1031(f) is that if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have essentially “cashed out” of the investment and the original exchange should not receive tax deferred.

The IRS tends to look at the related parties as a single economic unit and tax deferred exchange treatment will be disallowed if it is a part of a transaction or series of transactions structured to avoid the purposes of the related party provisions.

 

REVIEW OF LEGAL DEVELOPMENTS

TAM 102519-97: IRS ruled that an individual is not entitled to tax deferred treatment when purchasing a replacement property owned by a related party, even though a Qualified Intermediary (QI) purchased the replacement property. TAM 200126007: IRS denies tax deferred treatment when Exchanger wanted to sell residential property with a low basis and exchange for replacement property owned by a party related to the Exchanger.

The IRS felt this transaction involved “basis shifting” and a cashing out of the investment by an exchange between related parties. FSA 199931002: Exchanger should not exchange into a property owned by a related party when transferring the relinquished property to an unrelated party. FSA 2001137003: Exchanger can acquire a replacement property from a related party if the Exchanger and the related party are involved in a ‘swap’ and each hold their property for at least two years.

 

REVENUE RULING 2002-83

Revenue Ruling 2002-83 addresses the situation where an Exchanger transfers a relinquished property to a QI in exchange for a replacement property owned by a related party. The Revenue Ruling specifies that an Exchanger, under the facts shown below, is not entitled to non-recognition treatment under section 1031(a), if as part of the transaction, the related party received cash or other non-like-kind property for the replacement property.

 

Related Party 1031 Exchange Facts:

  • Exchanger A wants tax deferral under IRC Section 1031;
  • B is an entity related to Exchanger A;
  • C wants to buy A’s property

The Issue:

  • Exchanger transfers low basis relinquished property to QI;
  • QI sells relinquished property to C for cash;
  • QI acquires high-basis replacement property from B, transfers this property to A and pays B the cash received from C.

Result: Tax Deferred Treatment Denied

In essence, the Exchanger A enters into a like-kind exchange with QI, an unrelated third-party. The problem is that the end result is the same as if Exchanger A had exchanged with B followed by a sale from B to C.