When it comes to the holidays most people enjoy celebrating with their relatives. The wonderful family dinners, parties and exchanging gifts can be the highlight of the holiday season. However, when it comes to 1031 tax-deferred exchanges, you want to stay away from your relatives as much as possible. This Tuesday’s Tip discusses the concerns created when we exchange with a related party.
The definition of a related party for exchange purposes are family members such as parents, siblings, spouse, ancestors and lineal descendants. Those that are not considered related are aunts and uncles, cousins, nieces and nephews, ex-spouses and stepparents. Related parties are not just family members, it may also be a corporation, partnership or other entity of which more than 50% of the stock or capital interest is held by the same taxpayer directly or indirectly (§267(b) or §707(b)(1)).
Aggressive taxpayers with a low basis property have attempted exchanging with a related party for a high basis property so the related party could sell the property recognizing little or no gain. The IRS considers this structure to be tax avoidance and in 1989, subsection (f) was added to Internal Revenue Code Section 1031 imposing special rules for exchanges involving related parties. Section 1031(f) denies non-recognition treatment to a taxpayer exchanging property with a related party if the taxpayer or the related party would dispose of the property within a two year period. There is also a “catch-all” provision which states that if the taxpayer took a series of steps to avoid the transaction being classified as a related party transaction, it is still a related party transaction. The IRS will simply cut out all of the middle steps and see if you have arrived at the same result that you would have if you didn’t take the step(s).
The concern is primarily on exchanges involving someone acquiring replacement property from a related party where there is still an opportunity to abusively shift low basis property for high basis property. Until recently, many believed an exchange could take place as long as the transaction was “at arm’s length” and the taxpayer held the property for two years. However, Revenue Ruling 2002-83 clarified the position of the IRS that an acquisition from a related party in an exchange is clearly a violation of Section 1031(f).
Although the position is clear, this will probably not stop taxpayers from attempting to acquire replacement property from a related party. There may be some situations that will result in non-recognition of gain.
- The related party is also completing an exchange and no one is receiving boot.
- The related party pays more tax than Taxpayer would have if Taxpayer had not exchanged.
- Taxpayer is acquiring a larger tenant-in-common interest of property in which Taxpayer already owns an interest.
If Taxpayer proceeds, Taxpayer must adhere to a two-year holding period of the replacement property. There are a few exceptions to the mandatory two-year holding period. They are as follows:
- the Taxpayer or the related party dies;
- the disposition of the property in a compulsory or involuntary conversion (as defined in Section 1033); or
- Taxpayer or related party can successfully prove that the intention was not tax avoidance such as:
- transactions resulting in the Taxpayer holding a greater or entire interest in property;
- dispositions where tax was recognized; or
- transactions that did not involve shifting of basis.
Another subsection added in 1989 was Section 1031(g) which suspends the two-year holding period when the Taxpayer’s or related party’s risk of loss is substantially diminished by one of the following:
- the holding of a put;
- signing an Agreement of Sale agreeing to sell the property to a buyer; or
- a short sale or any other transaction.
Basically, if one of these situations arises the two-year holding period is halted and the entire original exchange transaction becomes taxable. A Taxpayer cannot sign an Agreement of Sale or a Lease Purchase Agreement within the two-year holding period either.
Recent Private Letter Rulings (PLR 200709036, 200712013 and 200728005) pertain to the sale of the relinquished property to a related party and allow the related party to sell said property within the two-year holding period. Exchanges involving the sale of relinquished property to a related party must be reported as a related party transaction on IRS Form 8824. While recent rulings seem to indicate IRS does not see exchanges involving the sale of relinquished property to a related party to be a violation of 1031(f), Taxpayer may want to use caution because the cost of defending their position may outweigh the tax benefits of the exchange.
So this holiday season, enjoy your time with relatives but a purchase from one of them as replacement property in your 1031 exchange may not provide the benefits you want and could lead to some not so pleasant discussions this time next year. Pass the eggnog please.
Contact our Exchange Team to discuss your transaction.
