When it comes to the holidays, most people enjoy celebrating with their relatives. The wonderful family dinners, parties, and gift exchanges can be highlights of the holiday season. However, when it comes to 1031 exchanges, you want to avoid a transaction with your close relatives and any related party. This article discusses the many concerns created when we exchange with a related party.
The definitions of related parties for exchange purposes include family members, such as parents, siblings, spouses, ancestors, and lineal descendants. Those not considered related are aunts and uncles, cousins, nieces and nephews, ex-spouses, and stepparents. Related parties are not just family members, but also close connections to a corporation, partnership, or trust.
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 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. A “catch-all” provision 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 to determine 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 an opportunity to shift low basis property for high basis property abusively. Until recently, many believed an exchange could occur 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 violates 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 are a few situations that will result in non-recognition of gain.
If Taxpayer proceeds, Taxpayer must adhere to a two-year holding period for the replacement property. There are a few exceptions to the mandatory two-year holding period. They are as follows:
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:
If one of these situations arises, the two-year holding period is halted, and the 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 the relinquished property to a related party must be reported as a related party transaction on IRS Form 8824. While recent rulings indicate that IRS does not see exchanges involving the sale of relinquished property to a related party as a violation of 1031(f), Taxpayers 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 purchasing 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.