Two 1031 exchange related party questions:
Question 1: Can you sell your property to a related party and still qualify for a 1031 tax deferred exchange?
Question 2: Can you buy your replacement property from a related party and still qualify for a 1031?
Sure and almost never. First let’s discuss who or what a related party is. Your definition and the IRS definition may be somewhat different so to comply with the code we must use the latter. The term “related party” means any person or party bearing a relationship to the taxpayer described in I.R.C. § 267(b) or 707(b)(1). Related parties include, but are not limited to, immediate family members, such as brothers, sisters, spouses, ancestors and lineal descendants, a corporation in which you have more than 50% ownership, a partnership/LLC in which you own more than a 50% interest and a fiduciary, grantor or beneficiary of the same trust. Related parties do not include stepparents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses, corporations in which you have 50% or less interest and partnerships/LLC in which you own 50% or less.
An exchangor can engage in a related party direct exchange which occurs when the related parties swap properties directly with each other simultaneously provided the exchange properties are held for two years. So an exchange may be made with a related party, however IRC Section 1031(f) imposes restrictions on these types of exchanges. Subsection (f) which was added to 1031 in 1989 denies non-recognition of the capital gain if either the related party or exchangor dispose of the property received within two years of the date of the last transfer which was part of the exchange. The 1031 Exchange will be disallowed and the corresponding depreciation recapture and capital gain income tax liabilities will be recognized should either the taxpayer or the related party dispose of either of the respective properties prior to the end of the two year holding period. The gain or loss from such a dis-allowance would be recognized on the date of the disposition of the subject property.
Answer to Question 1: The exchangor should be able to transfer its relinquished property to a related party in an exchange and acquire the replacement property from an unrelated party without violating the related property rules and the related party may sell the acquired property without a holding period. The related party may also acquire the relinquished property from the exchangor in a reverse exchange if the exchange accommodation titleholder has taken title to the replacement property in the reverse exchange. This allows the taxpayer to complete the reverse exchange within the 180-day reverse exchange period consequently the related party would have an unlimited time to sell the exchangor’s relinquished property. Exchangors should have a business purpose if they want to effect this type of transaction. The related party should be a real party in interest and not just a shell entity set up for the sole purpose of effecting this transaction, with the entity dissolving after the relinquished property is sold. The related party should bear the benefits and burdens of the ownership of relinquished property, and should not be acting as the taxpayer's agent. And finally the purchase price of the relinquished property should also be fair market value and supported by an appraisal.
Answer to Question 2: The purchase of the replacement property from a related party when selling the relinquished property to a non-related party will result in the IRS disallowing the exchange. The IRS Revenue Ruling 2002-83 published in 2003 makes it clear that regardless of the time the exchangor holds the new replacement property, the purchase of the replacement property from a related party without a simultaneous swap of properties between the related parties will not be allowed. The only exceptions to this rule are: 1.) When you purchase replacement property from a related party and your related party is also completing their own 1031 Exchange transaction using the sales proceeds from your purchase of their property, or 2.) If you can prove that the transaction did not result in an income tax basis swap to avoid part or all of the tax. In other words the related party is paying more tax than the taxpayer is deferring in the exchange. The related party would typically have little or no gain in the exchangor’s replacement property he acquired and the parties think it would be wonderful if they could get the exchange cash out for a minimal tax cost by just shifting low basis properties for high basis properties between related taxpayers. An exchangor who acquires replacement property from a related party must attach an explanation to the IRS Like-Kind Exchange Form 8824, which must be filed with the tax return, detailing why the transaction was not done with a tax avoidance purpose. The instructions published to aid with completion of Form 8824 are clear about the treatment of acquiring replacement property from a related party. The IRS has been adamant that there are only limited exceptions and it has been successful in challenging related party exchanges. Yet, many tax advisors still do not accept this. They maintain that the taxpayer need only hold the related party property for two years following the exchange.
Northern Bank, including its subsidiary Northern 1031 Exchange, LLC does not provide tax, legal or accounting advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. We strongly encourage you to seek appropriate professional advice regarding your specific facts and circumstances.
John Starling, senior vice president, Northern 1031 Exchange, LLC, Woburn, Mass.