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When considering purchasing from or selling to an individual or entity that is considered a “related party,” a taxpayer must take certain factors into consideration to have a successful exchange. In some cases an exchange may not work, or there may be a mandatory two-year holding period required for the replacement property. This article covers the basics of related-party exchanges, explaining why these rules exist, and how a taxpayer should approach a related-party exchange.
What is a related-party exchange?
A related-party exchange occurs when a taxpayer buys or sells real property from or to an individual or entity that is considered related to them under Sections 267(b) and 707(b) of the Internal Revenue Code. Related parties include a spouse, sibling, ancestors, and lineal descendants. In addition, if someone owns more than a 50% interest in a corporation or partnership, that corporation or partnership is considered a related party. The full definition of “related party” is located in the code sections referenced above.
Initially, related parties could exchange properties without any limitations. 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). For example, X has a property worth $1M with a basis of $100,000. He wants to sell but wants to avoid paying taxes on the $900,000 of gain. Y, his son, has a property worth $1M with a much higher basis of $950,000. X and Y exchange properties, each carrying over their basis from the property they exchanged. Y, now the owner of X’s former property, arranges with X to sell the property to a third party, triggering capital gains on $50,000. Taxes are only paid on that amount, instead of on the $900,000 that X would have realized had he not exchanged with Y. This scenario illustrates the core concepts of basis shifting.
Can a taxpayer exchange with a related party?
The answer to this question depends on whether the taxpayer is swapping properties with the related party, selling to them only, or purchasing from the related party.
Swapping with a related party
When swapping with a related party, such that a taxpayer relinquishes property to the related party and acquires replacement property from the same related party, an exchange is possible provided that both parties hold their respective replacement properties for a minimum of two years after the date of the last transfer that was part of the exchange. If either party transfers their property before that date, both exchanges will be disqualified, with both taxpayers obligated to pay tax on their gain. That tax will be payable for the tax year in which the sale of the property acquired in the exchange occurs.
In the past, some taxpayers have tried to avoid these restrictions by setting up their exchange with a related party using an intermediary. The theory was that because each taxpayer is technically exchanging with the intermediary, no related-party issues should arise. However, there have been several cases and rulings stating that using an intermediary does not exempt the taxpayer from the related party restrictions. This is based on the statement contained in IRC Section 1031(f)(4) that the benefits of Section 1031 do not apply “to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.”
There are a few exceptions to the rule, which are discussed below.
Selling to a related party
Generally, the view when selling to a related party in an exchange using an intermediary is that a taxpayer may proceed to exchange and acquire property from an unrelated party. Since the taxpayer is shifting its low basis to a property owned by an unrelated party, there is no cashing out of their investment in the same way as described above in a related-party swap. However, a taxpayer should always discuss the sale of property to a related party with a tax advisor, as there are other considerations to keep in mind – such as making sure the transaction is arm’s length.
Buying from a related party
When purchasing from a related party and selling to an unrelated party in an exchange, there are very limited instances in which a taxpayer can successfully defer gain. In many cases, the IRS and courts have disqualified such exchanges because of the potential for basis shifting. The basis shifting can occur and ruin the exchange even when it is unintentional.
However, there has been a Revenue Ruling and some cases indicating that a taxpayer may buy from a related party provided that the related party also completes an exchange (or is otherwise afforded non-recognition treatment and is not cashing out on their sale).
As discussed above, the related-party rules impose a two-year holding period for properties acquired in an exchange between related parties, 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.
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 where the taxpayer could prove that there was no intention of or resultant basis shifting or other avoidance of tax, but such taxpayer-friendly rulings have been very limited.
Given the potential roadblocks to completing a successful exchange when purchasing from or selling to a related party, it is essential that a taxpayer planning on doing so always discusses their transaction and goals with their tax advisor. This way they can ensure they are following any applicable rules to avoid disqualification of their 1031 exchange and a resultant tax penalty, even in a situation where the intention is not basis-shifting.
First American Exchange Company, LLC, a Qualified Intermediary, is not a financial or real estate broker, agent or salesperson, and is precluded from giving financial, real estate, tax or legal advice. Consult with your financial, real estate, tax or legal advisor about your specific circumstances. First American Exchange Company, LLC makes no express or implied warranty respecting the information presented and assumes no responsibility for errors or omissions. First American, the eagle logo, and First American Exchange Company are registered trademarks or trademarks of First American Financial Corporation and/or its affiliates.