By David M. Gorenberg, Esq.
The issue of the “related party exchange” is one of the most misunderstood aspects of §1031 exchanges.
Related parties are defined in IRC §267(b) and §707(b)(1) to include family members (siblings, spouse, ancestors and lineal descendants), corporations in which the taxpayer owns more than 50%, two corporations that are part of the same control group, grantors and fiduciaries of the same trust, and a litany of other business relationships.
Exchanges between related parties are permissible, but with special rules attached. IRC §1031(f) provides that if “a taxpayer exchanges property with a related person,” the taxpayer is entitled to §1031 non-recognition if both parties retain their property for two years from the date of the exchange. There are very narrow exceptions to this rule, that permit the shortening of the two year hold period, for such things as the death of either party, involuntary conversions, and for governmental takings by eminent domain.
Generally speaking, both the taxpayer and the related party receive non-recognition treatment under Section 1031(f) if both parties hold their respective properties for two years after the swap. If, however, either party disposes of their replacement property within that two year window, gain or loss recognition is triggered for both parties.
If the taxpayer is involved in an exchange where he transfers relinquished property to a related party and acquires replacement property from an unrelated party, the exchange will generally be recognized as valid – if both parties hold their new property for two years from the date of the last transfer that was part of the taxpayer´s exchange.
When the taxpayer transfers his relinquished property to an unrelated third party, and acquires his replacement property from a related party, two possible results are found. First, if the related party was also doing an exchange, both exchanges are likely to be successful. Again, both parties will be required to hold their new properties for two years.
However, if the related party was not doing an exchange, and simply sold his property to the taxpayer, Revenue Ruling 2002-83 tells us that the taxpayer´s exchange fails. The IRS interprets this as a series of transactions designed to enable the taxpayer to “cash out” of his investment, in an effort to circumvent §1031(f). In this Revenue Ruling, the IRS relied heavily on IRC §1031(f) (4), the so-called “Anti-Abuse” provision, which denies deferral “to any exchange, which is part of a transaction (or series of transactions) structured to avoid the purposes of” the related party rules.
Great care must be taken, as the two year holding period can be tolled, or suspended, where either the taxpayer´s or the related party´s risk is substantially reduced by either: (a) the holding of a put with respect to the property they hold; (b) the holding by another person of a right to acquire the property; or (c) a short sale or similar transaction. If either of these factors exists, the holding period is tolled, and the two-year holding period does not resume running until the factor ceases to exist.
Further, the latest version of Form 8824 specifically asks whether “the exchange of property given up or received [was] made with a related party, either directly or indirectly (such as through an intermediary)”. If the answer is affirmative, the name, address, and taxpayer identification number of the related party, as well as the nature of the relationship must then be disclosed. Exchanges involving related parties also require that Form 8824 be filed for the year of the exchange, and for the two years following the exchange. {Form 8824, Instructions.}
While all 1031 exchanges required careful planning, related party exchanges involve substantially greater risks.
LandAmerica 1031 Exchange Services cannot advise taxpayers concerning the specific tax consequences or the advisability of a tax-deferred exchange. It is strongly urged that taxpayers consult their tax and legal advisors before undertaking a like-kind exchange.
David M. Gorenberg, Esq., is Certified Exchange Specialist ® and Vice President of LandAmerica 1031 Exchange Services. LandAmerica Exchange Company is a leader in facilitating like-kind exchanges, whether for real estate, aircraft, or other assets. Copyright© 2005, David M. Gorenberg, Esq. All rights reserved.For information about Keynote Presentations, contact Frog Pond at 800.704.FROG(3764) or email [email protected]; http://www.frogpond.com
