This Tuesday’s Tip reminds everyone that 1031 tax-deferred exchanges between related parties should be carefully considered as these types of transactions have received considerable attention from the IRS recently.
Aggressive taxpayers with a low basis property were exchanging with a related party for a high basis property and the related party would 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 the taxpayer 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 clarifies 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.
- The related party pays more tax than the Taxpayer would have if taxpayer had not exchanged.
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;
- the holding of by another of a right to acquire the property (for example, 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.
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.
Under IRC §267(b) and §707(b), a related party is any party bearing a relationship to the taxpayer. Any one of the following is considered a related party:
- Family members such as siblings, spouse, ancestors and lineal descendants;
- Individual and corporation where more than 50% in value of the stock is owned directly or indirectly by or for such individual;
- Two corporations part of the same control group;
- A grantor and a fiduciary of the same trust;
- A fiduciary and a beneficiary of the same trust;
- A fiduciary of a trust and the fiduciary or beneficiary of another trust where the same person is the grantor of both trusts;
- A fiduciary of a trust and a corporation more than 50% in value of the outstanding stock in which is owned, directly or indirectly, by or for the trust or by or for the grantor of the trust;
- A person and a Section 501 (non-profit) organization, if the organization is controlled by that person or that person’s family;
- 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 capital interest or profits interest in the partnership;
- An S corporation and another S corporation or a C corporation if the same persons own more than 50% of the value of the outstanding stock of each corporation;
- A partnership and a person owning, directly or indirectly, more that 50% of the capital interest, or profits interests, in such partnership;
- Two partnerships in which the same persons own, directly or indirectly, more than 50% capital interests or profit interests; and
- An executor of an estate and the beneficiaries of the estate.
Every situation is different and you should discuss yours with your tax and/or legal advisor. Please contact your 1031 CORP. Exchange Officer for more information if considering an exchange between related parties.
