IRS Rules for 1031 Exchanges Between Related Parties
**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**
In this guide we’ll explain in detail what qualifies as a related party member and what IRS rules apply to a 1031 exchange between related parties.
Prior to Congress amending Section 1031 in 1989, significant tax avoidance was occurring in a 1031 exchange between related parties. Investors were swapping properties with low tax-basis for those with high ones.
This was often motivated by the desire to sell the low basis property without incurring a large capital gain. Once acquired in a 1031 like kind exchange related party transaction, the high basis properties were often being disposed of promptly with little or no gain realized.
The 1989 amendment changed all that. Now there’s a two year wait before disposing of property received from a related party in an exchange.
But before discussing the waiting period and other details, let’s determine what a related party is.
What Qualifies as a Related Party Relationship?
Related parties are defined under Sections 267(b) and 707(b)(1) of the Internal Revenue Code. It’s not all about natural persons, but a related party member does include your immediate family. Not included are stepparents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.
A related party is not necessarily a family member. It can also be a corporation, limited liability company or partnership. Let’s say you own more than 50% of the
- stock, membership interests or partnership interests, or
- more than 50% of the capital interests or profit interests of another company.
Then, that entity is considered a related party. Note that it’s possible to change the ownership of related parties in advance of contemplated exchanges. You could transfer or dispose of partnership interests or shares in a corporation. You might just want to reduce the ownership interest to or below the 50% level. That’s the point at which an entity loses its related party identity.
What are the Rules Applying to 1031 Exchanges Between Related Parties?
IRC Section 1031(f)(4) disallows tax-deferred exchange treatment in any 1031 exchange between related parties that …is part of a transaction (or series of transactions) structured to avoid … the purpose of related-party rules. Effectively, 1031(f) denies tax deferral when related parties perform an exchange of low-tax basis for high basis property in anticipation of selling it.
The rationale is that if property in a 1031 exchange with a related party is then promptly sold, the related parties have essentially cashed out. This is a clear violation of 1031 like kind exchange rules. With its focus on the substance over form doctrine, that outcome isn’t lost on the IRS. As such the initial exchange would not be accorded nonrecognition treatment.
Outside of a few exceptions, the IRS deems a holding period less than two-years as prima facie evidence of tax avoidance motivations. Effectively any property disposition by either related party before two years after the date of the last transfer will revoke the exchange’s tax deferral provisions. This catchall prohibition causes many like kind exchange related party transactions to fail.
Say your relinquished property is sold to a third party and replacement property acquired from a related party. Since you did not exchange properties with your related party, the two-year statutory requirement does not apply directly.
Nonetheless, you likely cannot invoke 1031 nonrecognition provisions if–within two years of the last transfer–either you or the related party dispose of replacement or relinquished property, respectively.
Again, the IRS presumes tax avoidance motivated the exchange when holding periods are under two years. So absent a qualifying exception covered here in a later section, the exchange will fail to provide for desired tax deferrals.
What’s About Unrelated Qualified Intermediary Exchanges?
Under Revenue Ruling 2002-83, an Exchanger won’t receive exchange treatment even though an unrelated Qualified Intermediary acquires replacement property from the related party for cash or other non-like-kind property. It’ll also be inconsequential whether the Exchanger holds the replacement for two years.
Say you want to sell low-tax basis property while deferring taxes under a 1031 exchange between related parties. An unrelated party wants to acquire that property. You transfer the relinquished property to a Qualified Intermediary (also often referred to as 1031 exchange companies).
- sells the relinquished property to the unrelated party for cash,
- acquires high-basis replacement property from your related party, and
- transfers this property to you and pays the related party cash.
The IRS will view this transaction from a form over substance perspective. Clearly, it’s as if the Exchanger exchanged properties with a related party. Whereupon the related party immediately sells the property for cash, an unlike kind exchange. No surprise, related party rules under 1031(f) cannot be circumvented by involving an unrelated Qualified Intermediary.
To learn more about everything a QI does for you, read out guide All About 1031 Exchange Accommodators (aka Facilitators or Qualified Intermediaries).
Exceptions to Related Party Rules
Field Service Advice (FSA) Memorandum 2001-37003, the IRS concluded that …the two-year rule in Section 1031(f)(1)(C) is a safe harbor that precludes application of Section 1031(f)(1) to any transaction falling outside that period… [emphasis added]
The memorandum states that these provisions are intended to stop tax avoidance-motivated 1031 exchanges. They should not however preclude you from disposing of property after the two years. Further, you may even start a 1031 exchange between related parties intending to sell after two years. So planning this in advance will not trigger gain recognition.
There are a few exceptions to the two-year rule. Section §1031(f)(2)(C) essentially provides an override to the two-year disposition of property holding period. Transactions under two years won’t be disqualified if … 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.
Not an easy case to make with tax deferral the main objective of 1031 exchanges. But here are a few favorable IRS rulings:
- Related parties owning only fractional interests in multiple properties were given full ownership in one or more properties. Each member was giving full ownership in one or more properties. The IRS agreed there was no 1031 rules violation.
- Also successful was a disposition caused by an involuntary conversion under IRC Section 1033 of the Internal Revenue Code.
- Another exception was based on a private letter ruling 201220012 regarding disposal of replacement property within two years. The ruling reads in part … with related parties provided that (A) each related party transferring replacement property into the exchanges described in this letter is also engaging in its own like-kind exchange and (B) PT [prime taxpayer], Affiliate and Related Party hold their replacement properties for at least two years after the date of the last transfer of property in the exchanges. [emphasis added]
- The IRS has ruled that conveying like-kind replacement property acquired in a 1031 exchange into a fully revocable grantor trust (of which you are the sole trustor and beneficiary) won’t be considered a replacement disposition. As such it did not result in the recognition of taxable income.
- Finally, a rarely used exception to the two-year requirement occurs in the event of the death of the taxpayer or the related person. This allows for the exchanged property to be sold within two years while still retaining the initial tax deferral.
Bottom-line exceptions to the two-year holding rule are possible if you can prove that tax avoidance wasn’t your motivation for the property transfer. As always, the burden of proof will be on you.
Under IRC 1031(f)(2)(C) and (f)(4), a related party exchange will be disallowed if transaction(s) are structured to avoid taxes or other purposes of related party rules. The IRS and Courts generally focus on overall tax outcomes of transactions with related parties.
This rationale extends beyond just whether there’s a tax basis shifting when replacements are purchased from related party sellers. Disqualifications could also occur if the related seller ultimately pays less tax on a replacement sale than they would have paid on a relinquished property sale. This might ocurr when net operating losses or lower tax rate are available to the related seller.
Conversely, the IRS has upheld exchanges where it was demonstrated that there was no basis shifting and that tax avoidance was not a prime motivation. This has been true even when taxpayers and related parties swapped properties, and then the related buyer disposed of the property.
The IRS has ruled that 1031(f)(4) won’t nullify nonrecognition treatment when transactions were not intended to avoid the purposes of section 1031(f)(1) since no tax basis shift resulted.
However, as discussed here earlier, even those rulings may come into question if the two-year holding period is not observed. Seeking professional advice here on a case by case is imperative especially if large tax dollars are at stake.
The focus need be on the paragraph within IRS’ related-party rules that reiterates IRS’ well-established substance over form doctrine. Paragraph 1031(f)(4) states that the rules applying to related-party transactions …will cease to operate if a transaction (or series of transactions) is structured to avoid the purpose of those rules. [emphasis added].
This open ended declaration is clearly designed to discourage using 1031 exchanges between related parties as a vehicle for tax avoidance.
How to Do Your 1031 Exchange Legally?
Unless you are doing a simultaneous 1031 exchange, you must use a Qualified Intermediary. Professional QIs are experts in all aspects of 1031 exchanges. A reputable 1031 exchange company with tax attorneys on their team will consult you and your tax advisor/CPA. They will advise on whether your exchange plan satisfies the IRS requirements or it needs adjustments to perfectly comply with the rules.
PropertyCashin is an all-in-one platform for commercial real estate investors that maintains relationships with top-rated 1031 exchange firms in all locations of the USA. To get connected with the best professionals and have your exchange processed safely and effectively, fill out the form below.