There has been considerable abuse over the years by investors who have used various "related party" strategies or techniques to defer, avoid and even evade the payment of their income tax liabilities. 1031 Exchanges have certainly not been immune to such tax abuse, and the Internal Revenue Service ("IRS") has issued rules and guidelines on related party 1031 Exchange transactions to curb such investor abuse.
The 1031 Exchange related party rules or guidelines were intended by the Internal Revenue Service to prevent investors from using the 1031 Exchange to shift tax cost basis between properties owned by related parties in order to reduce the overall amount of depreciation recapture and capital gain taxes recognized and paid on the sale of a specific property.
This practice, also referred to as cost basis swapping, involves the sale and 1031 Exchange of property that has a low tax cost basis (and therefore a large capital gain) for property owned by a related party that has a high tax cost basis (and therefore a small capital gain) in order to reduce or eliminate the overall taxes paid by the related parties.
Generally, the investor defers all of his or her taxes and the related party that sold the high basis property merely "cashes out" and pays little or no taxes after the transaction closes.
Related party 1031 Exchange transactions occur when you sell your relinquished property to a related party or you buy your like-kind replacement property from a related party. Related party 1031 Exchanges are permitted provided you follow specific rules and guidelines issued by the Internal Revenue Service. Related party issues can also be avoided altogether if the related party relationship is eliminated prior to structuring and completing the 1031 Exchange transaction.
The definition of related parties is a combination of related parties as defined pursuant to Sections 267(b) and 707(b) of the Internal Revenue Code. Related parties include, but are not limited to, immediate family members, such as brothers, sisters, spouses, ancestors and lineal descendents. Related parties do not include stepparents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.
Corporations, limited liability companies or partnerships in which more than 50% of the stock, membership interests or partnership interests, or more than 50% of the capital interests or profit interests, is owned by the taxpayer is considered to be a related party.
The taxpayer and the related party must hold the properties that each received as part of the 1031 Exchange transaction for a minimum of two (2) years. The two (2) year holding period starts running on the date of the transfer or conveyance of the last property involved in the 1031 Exchange related party transaction.
These related party rules and guidelines do not prohibit or bar any related-party transactions, but merely requires a longer holding period in order to qualify for the tax-deferred exchange treatment under Section 1031.
The tax-deferred status of the 1031 Exchange will be disallowed and the corresponding depreciation recapture and capital gain income tax liabilities will be recognized should either the taxpayer or the related party dispose of either of the respective properties prior to the end of the two (2) year holding period. The gain or loss from such a disallowance shall be recognized as of the date of the disposition of the subject property.
The 1031 Exchange transaction will not be disallowed if either of the properties is disposed of within the two (2) year holding period where and when:
Related parties who concurrently 1031 Exchange or swap properties with each other must hold the properties for two (2) years following the concurrent 1031 Exchange. Both related parties will recognize their respective depreciation recapture and capital gain income tax liabilities if either party disposes of its respective property within two (2) years after the simultaneous 1031 Exchange or transfer.
It is clear that a taxpayer can dispose of (sell) his or her relinquished property to a related party and acquire like-kind replacement property from a non-related party without violating the related party rules and guidelines. The related party must hold the relinquished property acquired from the taxpayer for a minimum of two (2) years, and the taxpayer must hold the replacement property acquired as part of the 1031 Exchange for a minimum of two (2) years in order to qualify for tax-deferred treatment.
However, it appears that you may not be able to dispose of (sell) relinquished property to a non-related party and acquire like-kind replacement property from a related party without recognizing depreciation recapture and capital gain income tax liabilities.
Most 1031 Exchange transactions structured with the purchase of the replacement property being acquired from a related party will result in tax basis swapping, whether intentional or not. The Internal Revenue Service issued Revenue Ruling 2002-83 on November 25, 2002, which establishes its position on related party 1031 Exchange transactional structures.
However, you are generally entitled to defer income tax liabilities when you purchase property from a related party and your related party is also completing their own 1031 Exchange transaction using the sales proceeds from your purchase of the related party's property, or if you can prove that the transaction did not result in an income tax basis swap (tax avoidance).
The Internal Revenue Service has previously ruled that conveying the like-kind replacement property acquired as part of your 1031 Exchange related party transaction into a fully revocable grantor trust, of which you are the sole trustor and beneficiary, will not be considered to be a disposition of the subject property and will not result in the recognition of your income tax liabilities.
However, Section 1031(f)(4) of the Internal Revenue Code provides that tax-deferred exchange treatment is not permitted in any 1031 Exchange that "is part of a transaction (or series of transactions) structured to avoid" the purpose of the related-party rules.
This catchall anti-abuse provision causes many related party 1031 Exchanges to fail and is often misunderstood or overlooked. Transactions structured specifically for the purpose of avoiding income tax liabilities (income tax avoidance or tax evasion) utilizing a related party 1031 Exchange structure will be disqualified by the Internal Revenue Service.
Recent IRS Rulings and Guidance
Application of this anti-abuse provision through the use of a professional Qualified Intermediary in a related-party 1031 Exchange has resulted in a number of IRS rulings. The most recent ruling is Revenue Ruling 2002-83. This ruling prevents related parties from deferring capital gains through the use of a Qualified Intermediary when the related party receives cash or non–like-kind property (i.e. "cashes out").
Let's review an example. John owns Property A worth $100,000 with a basis of $10,000, and his brother Sam owns Property B worth $100,000 with a basis of $100,000. Jackie, an unrelated party, wants to acquire Property A for $100,000. To complete the transfer, John enters into an agreement to exchange Property A and B with Sam, Jackie, and a Qualified Intermediary that is unrelated and independent of John and Sam. John transfers his low-basis Property A to the Qualified Intermediary. The Qualified Intermediary then exchanges Property A with Jackie for cash, and the Qualified Intermediary acquires the high-basis Property B from Sam for cash, and subsequently transfers Property B to John. John has engaged in a 1031 Exchange with a Qualified Intermediary (an unrelated third party) instead of with Sam.
The end result of this 1031 Exchange transaction, if one eliminates the Qualified Intermediary from the picture, is as follows: John and Sam have 1031 Exchanged properties, and Sam sold the property received in the 1031 Exchange to Jackie for cash. According to the ruling, a related party is not entitled to tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code if the related party receives cash or other non–like-kind property (i.e. effectively cashes out) for the property received in a transaction that uses a Qualified Intermediary to 1031 Exchange the property. In our example, Sam received non–like-kind property (i.e. cash); so, Section 1031 does not apply, and John must recognize his gain of $90,000.
In making the ruling, the IRS relied on the anti-abuse provision of Section 1031(f)(4) of the Internal Revenue Code, holding that the Qualified Intermediary was used to circumvent the purpose of the related-party rules and, therefore, the tax-deferred exchange provisions of Section 1031 do not apply.
In Technical Advice Memorandum (TAM) 9748006, the IRS used the same approach for analyzing a 1031 Exchange involving related parties, a Qualified Intermediary, and an unrelated third party. In general, the IRS looks to the final outcome to determine whether a related party "cashed out." If a related party has cashed out, then the transaction will not qualify for tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code.
TAM 2001-26007 involves a complicated set of transactions between two corporations meeting the related-party definition due to common stock ownership by members of two families. The transactions involved a Qualified Intermediary and two unrelated parties. Ultimately, the transactions shifted the taxpayer’s low basis in its property to the replacement property previously owned by the related party. The related party eventually received cash that it used to reduce bank debt. In the end, the related party "cashed out" of its investments, denying the taxpayer nonrecongition treatment on the transactions.
Field Service Advice (FSA) Memorandum 2001-37003 provides that if related parties 1031 Exchange properties, nonrecognition treatment of the gain is permitted as long as the subsequent disposition of the replacement property occurs after two years of the initial exchange.
The IRS concluded that "the two-year rule in Section 1031(f)(1)(C) is a safe harbor that precludes application of Section 1031(f)(1) to any transaction falling outside that period.” Therefore, related parties can avoid the anti-abuse rules just by waiting two years. The FSA states that the purpose of the anti-abuse provisions is to “stop taxpayers from violating the two-year rule, and not to preclude taxpayers from planning to dispose of property after the two-year period.” Taxpayers can enter into a related-party 1031 Exchange with the intent of selling the property after two years without triggering recognition of the original gain as long as the transaction was not a sham.
1031 Exchange Related Party Planning Considerations
The opportunity for tax deferral, available for all 1031 Exchanges, still applies to related-party 1031 Exchange transactions. In many situations, tax deferral coupled with estate planning objectives make the related-party 1031 Exchange a very attractive strategy.
From an estate planning perspective, 1031 Exchanges may result in taxes never being paid on the investment. If a taxpayer who has participated in a 1031 Exchange dies, the property is left to heirs and the heirs receive a step-up in cost basis. This means that the capital gain and depreciation recapture taxes are eliminated.
The shifting of basis still works for related parties, but requires a little more work. For example, a taxpayer who owns a property with low basis that has appreciated significantly can still consider 1031 Exchanging the property with a related party that owns investment property with a higher basis. The related parties can avoid the anti-abuse provision by waiting two years to sell the property.
For example, a parent owns investment land that is appreciating significantly. The area where the land is located is beginning to develop and the parent knows that the property will eventually be sold. A child has rental property that generates income but is not appreciating as rapidly. The child does not need the rental income and the parent could use the income to supplement his retirement. Structuring a 1031 Exchange is an ideal strategy here. Not only will the tax on the ultimate sale be lower because of the child’s higher basis, but also the additional appreciation during the two-year holding period will have been transferred to the child.
IRS Form 8824, Like-Kind Exchanges, must be filed when a 1031 Exchange involving like-kind property occurs. When related parties exchange property, additional information is required, including the name, address, taxpayer identification number or social security number, and relationship of the related party.