1031 Exchange Rules: Related Parties
The Internal Revenue Code Section 1031 was changed to reflect exchanges between related persons in the Omnibus Budget Reconciliation Act of 1989. Subsequent additions were made in the early 1990s that further refined related party 1031 exchange transactions. The reason for the regulations was to prohibit basis shifting between related parties. Basis shifting is when a property with a high adjusted basis is exchanged for a property with a low adjusted basis or a strategy of interdependent steps to avoid or diminish federal income taxes.
Related Party Definition
A related party is defined as any family member of the exchangor including:
- lineal descendants
- grantor and fiduciary
- fiduciary and a beneficiary of the same trust
- executor and beneficiaries of the estate
Other related parties include the exchangor and a corporation or partnership where more than 50 percent in stock value is directly or indirectly owned by or for exchangor, or a corporation and a partnership if the same exchangors own more than 50 percent in outstanding stock value of the corporation and more than 50 percent of the capital or profit interest in the partnership.
Selling to Related Party
The disposition of a property to a related party is permissible given the related party does not sell the property within two years of the transaction and the exchangor acquires a replacement property from an unrelated third party to complete the exchange. If the related party sells the acquired property within two years of the purchase, the tax deferred by the exchangor is imposed.
There are exceptions to the two year rule permitting the sale and not resulting in a failed exchange including:
- Disposition of property following the exchangor’s or related person’s death
- Disposition in a compulsory or involuntary conversion in a Section 1033 given the threat of imminence occurred after the exchange
- Purpose of disposition is not the avoidance of federal income tax.
Acquiring from a Related Party
The exchangor may acquire the replacement property from a related party given the related party is also initiating a 1031 exchange and not cashing out. Do not misinterpret this as the exchangor exchanging property with an unrelated party, acquiring replacement property from related party and holding for two years. Whenever a related party is involved in a 1031 exchange, the exchange must satisfy the non-tax avoidance motive of whether a low tax basis was shifted into high basis property.
Tax Avoidance of Step Transactions
Planned transactions to circumvent related party rules may be considered a step transaction resulting in the 1031 exchange being disallowed. In Kornfeld v. C.I.R., 10th Circuit 1998, the step transaction doctrine was applied to disallow a related party exchange because the taxpayer engaged in a series of steps in addition to the exchange to turn an expenditure for nondepreciable land into depletable, stepped up basis in oil and gas leases.
On Form 8824, Like-Kind Exchanges, line 7, The Internal Revenue Service (IRS) asks whether the property of the exchange was sold to or acquired from a related party. Form 8824 instructions state that if the taxpayer can present to the satisfaction of the IRS, that tax avoidance was not the primary purpose of the exchange, an explanation should be included when filing the form. Otherwise, do not report the transaction on Form 8824 and consider the 1031 exchange disallowed. Recent related party Tax Court cases to consider include Teruya Brothers, Ltd. & Subsidiaries and Ocmulgee Field, Inc.
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