Related Party Issues in 1031 Exchanges

RELATED PARTY ISSUES

The IRS issued Related Party Rules in 2002 to prevent taxpayers from qualifying for non-recognition treatment under Section 1031 of the Internal Revenue Code, if either party disposes of the property received within two (2) years of their 1031 exchange.

In addition, Section 1031(f) of the Internal Revenue Code states that taxpayers who cannot prove that their 1031 exchange does not have the main purpose of tax avoidance or of avoidance of the related party issue will risk having their 1031 exchange invalidated.

Who is a related party?

Related parties include family members, such as brothers, sisters, spouses, ancestors (parents, grandparents, etc.) and lineal descendents (kids, grandkids, etc.). Related parties do not include stepparents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.

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 is also considered to be related parties.

Two-Party Simultaneous Exchange

Related parties who swap properties with each other must hold the property for two (2) years following the 1031 exchange. Both parties will recognize capital gain if either party disposes of the property received within two (2) years after acquiring it.

Delayed Exchange – Sale to Related Party

The IRS has not invalidated delayed exchange transactions in which a taxpayer sells to a related party, as long as the related party holds the property for a minimum of two (2) years. In this scenario, a purchase of a relinquished property by a related party results in a new adjusted cost basis to the related party for the property. The adjusted cost basis of the relinquished property is shifted or deferred to the replacement property acquired by the taxpayer from an unrelated party.

Delayed Exchange – Purchasing from a Related Party

The IRS does not look favorably on a delayed exchange transaction in which the taxpayer purchases a replacement property from a related party. The issue here is whether the transaction results in "basis swapping" in order to avoid taxation.

By 1031 exchanging a relinquished property with a low adjusted cost basis (i.e. large capital gain) for property from a related party with a very high adjusted cost basis (i.e. little or no capital gain) the taxpayer defers his or her capital gains and the related party cashes out with no tax consequences.  This is a classic basis swapping transaction. 

Revenue Ruling 2002-83

Revenue Ruling 2002-83, issued November 25, 2002, establishes the IRS position on 1031 exchanges between related parties. A taxpayer who transfers relinquished property to an unrelated party through a Qualified Intermediary in exchange for replacement property from a related party is not entitled to non-recognition treatment.

However, taxpayers are generally entitled to defer capital gain taxes when they purchase from a related party if the related party is completing their own 1031 exchange with the sales proceeds from the transaction or if they can prove there is no basis swapping involved or there is no tax avoidance. 

Related Party Defined

A related party is defined under Sections 267(b) and 707 (b)(1) of the Internal Revenue Code as any of the following:

• Members of a family
• An individual and a corporation in which more than 50% of the value of the outstanding stock is owned directly or indirectly by or for such individual.
• Two corporation which are in the same controlled group (as defined in subsection (f);
• A grantor and a fiduciary of any trust;
• A fiduciary of a trust and a fiduciary of another trust, if the grantor is the same for both trusts;
• A fiduciary of a trust and a beneficiary of such trust;
• A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;
• A fiduciary of a trust and a corporation in which more than 50% of the value of the outstanding stock is owned, directly or indirectly, by or for the trust or by or for a person who is grantor of the trust;
• A person and an organization to which section 501 (relating to certain educational, charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual.
• A corporation and a partnership if the same persons own:
  • more than 50% in value of the outstanding stock of the corporation, and
  • more than 50% of the capital interest, or the profits interest, in the partnership.
• An S corporation and another S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.
• An S corporation and a C corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.
• Except in the case of a sale or an exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.