1031 Exchange

What is a related party transaction? When a taxpayer, in an exchange, sells relinquished property to a related party or acquires replacement property from a related party.

Who is a related party? Any person bearing a relation to the taxpayer as described n IRC 26;7(b) or 707(b)(1), including family members such as siblings, a spouse, ancestors and lineal descendants. An individual is considered to be related to an entity e.g., a partnership, LLC or corporation, if they own more than 50% of that entity.

What is all the fuss about? If a taxpayer sells relinquished property to a related party, the related party must hold that property for two years and the taxpayer must hold his replacement property for two years after the exchange. See, IRC 1031(f)(1). If a taxpayer buys replacement property from a related party, or a related party owned the replacement property in the preceding two years, the taxpayer must hold the replacement property for two years. See 1031 (f)(1). If either party sells within the two year period, the gain deferred by the original exchange will be recognized as of the date of the later sale. Section 1031(f)(4), provides that the non-recognition provision of 1031 will not apply to any transaction or period of transactions structured to avoid the purposes of 1031 and the two year hold requirement.

Section 1031(f) was originally enacted to prevent the practice of "basis shifting" among related parties. Basis shifting occurs when related parties exchange high basis property for low basis property in anticipation of a subsequent sale of the low basis property. In short, the low basis property ends up in the hands of the related party a new high basis and can be sold without the recognition of gain.

An example of the IRS's disdain for related party transactions is shown by PLR 9748006, issued in 1007, wherein the taxpayer sold his relinquished property to an unrelated party and attempted to acquire property from an unrelated party. When the taxpayer could not acquire the intended replacement property, in order to complete his exchange, he instead acquired property from his mother. Even though the taxpayer's mother paid tax on the gain related to her sale, the IRS disallowed the taxpayer's exchange, holding that the result of a series of transactions was the same as if the taxpayer had swapped his property for his mother's followed by the mother's immediate sale of the taxpayer's property to a third party. The IRS state that a related party exchange, followed shortly thereafter by a disposition of the property, is, in effect, a "cashing out" of the investment and the exchange should not be allowed.

In November 2002, the IRS issued Revenue Ruling 2002-83, again disallowing non-recognition treatment in a transaction wherein the taxpayer acquired replacement property from a related party. In that ruling, the IRS indicated, however, that if the related party receives no cash or receives like king property. The transaction should be allowed, notwithstanding the related party rule, when the related party also engages in an exchange. In June 2004, the IRS resolved that question by issuing PLR 2004-40002, wherein a partnership sold relinquished property to a third party and purchased replacement property from a related partnership. The related partnership also did an exchange, and non-recognition treatment was allowed.

What is the bottom line? A taxpayer should avoid selling relinquished property to or buying replacement property from a related party, unless all parties in the transaction are willing to meet the two year holding period. And, in the case of buying from a related party, the related party must also complete an exchange.

Disclosure Note: This information is subject to interpretation and meant to help the consumer understand information surrounding a transactional nature for 1031 exchange. It is important to seek specific and individual guidance and information from you financial advisor. This information is merely an overview and is not intended to be exhaustive. Consult with your tax advisor to determine whether an exchange is appropriate for your circumstances.

1031 Exchange - Related Parties

Related Party Transactions in a Nutshell


	1031 Exchange - Related Parties
	Related Party Transactions in a Nutshell
		What is a related party transaction? When a taxpayer, in an exchange, sells relinquished property to a related party or acquires replacement property from a related party. Who is a related party? Any person bearing a relation to the taxpayer as described n IRC 26;7(b) or 707(b)(1), including family members such as siblings, a spouse, ancestors and lineal descendants. An individual is considered to be related to an entity e.g., a partnership, LLC or corporation, if they own more than 50% of that entity. What is all the fuss about? If a taxpayer sells relinquished property to a related party, the related party must hold that property for two years and the taxpayer must hold his replacement property for two years after the exchange. See, IRC 1031(f)(1). If a taxpayer buys replacement property from a related party, or a related party owned the replacement property in the preceding two years, the taxpayer must hold the replacement property for two years. See 1031 (f)(1). If either party sells within the two year period, the gain deferred by the original exchange will be recognized as of the date of the later sale. Section 1031(f)(4), provides that the non-recognition provision of 1031 will not apply to any transaction or period of transactions structured to avoid the purposes of 1031 and the two year hold requirement. Section 1031(f) was originally enacted to prevent the practice of "basis shifting" among related parties. Basis shifting occurs when related parties exchange high basis property for low basis property in anticipation of a subsequent sale of the low basis property. In short, the low basis property ends up in the hands of the related party a new high basis and can be sold without the recognition of gain. An example of the IRS's disdain for related party transactions is shown by PLR 9748006, issued in 1007, wherein the taxpayer sold his relinquished property to an unrelated party and attempted to acquire property from an unrelated party. When the taxpayer could not acquire the intended replacement property, in order to complete his exchange, he instead acquired property from his mother. Even though the taxpayer's mother paid tax on the gain related to her sale, the IRS disallowed the taxpayer's exchange, holding that the result of a series of transactions was the same as if the taxpayer had swapped his property for his mother's followed by the mother's immediate sale of the taxpayer's property to a third party. The IRS state that a related party exchange, followed shortly thereafter by a disposition of the property, is, in effect, a "cashing out" of the investment and the exchange should not be allowed. In November 2002, the IRS issued Revenue Ruling 2002-83, again disallowing non-recognition treatment in a transaction wherein the taxpayer acquired replacement property from a related party. In that ruling, the IRS indicated, however, that if the related party receives no cash or receives like king property. The transaction should be allowed, notwithstanding the related party rule, when the related party also engages in an exchange. In June 2004, the IRS resolved that question by issuing PLR 2004-40002, wherein a partnership sold relinquished property to a third party and purchased replacement property from a related partnership. The related partnership also did an exchange, and non-recognition treatment was allowed. What is the bottom line? A taxpayer should avoid selling relinquished property to or buying replacement property from a related party, unless all parties in the transaction are willing to meet the two year holding period. And, in the case of buying from a related party, the related party must also complete an exchange. Disclosure Note: This information is subject to interpretation and meant to help the consumer understand information surrounding a transactional nature for 1031 exchange. It is important to seek specific and individual guidance and information from you financial advisor. This information is merely an overview and is not intended to be exhaustive. Consult with your tax advisor to determine whether an exchange is appropriate for your circumstances.