Related Party Transactions In A 1031 Exchange

Saturday, April 22, 2017

Related parties and related entities are described in Internal Revenue Code (IRC) Section 267(b) and 707(b)(1). Those laws can be summarized as: “Related parties” include individuals who are lineal ancestors or descendants, brothers and sisters and spouses. Related business entities include corporations, partnerships, and LLCs in which the taxpayer (or a related individual) holds a fifty percent or greater interest. Parties also include an estate in which you are a beneficiary or a trust of which you are a beneficiary. Aunts, uncles, cousins, nephews and relations by marriage (except spouses) are not considered. Planning opportunities exist.  For example a son in law can purchase replacement property from his in laws without running afoul of the rules.

Deed swaps, or what is commonly known as a "two party exchange", between related parties require that both parties hold the property they acquire for 24 months to protect the tax deferral of  the 1031 exchange. The purpose of this rule is to prevent what is known as basis swapping. For example let's say dad owns a million dollar apartment building with a $200K basis and son owns a million dollar apartment building with a $900K basis. Dad gets an offer to sell his building. This would result in a gain of $800K. Instead he swaps(1031 exchanges) his building with his son and the son completes the sale with a gain of only $100K. Tax deferral in the1031 exchange between father and son is disallowed unless both father and son hold their "new" property for 24 months after the exchange. Again, planning opportunities exist. These intra-family 1031 exchanges are perfectly acceptable as long as the two year hold rule is followed.

In the more typical "three party" 1031 exchange, a sale of relinquished property to a  related party with the purchase of the replacement property from an unrelated party is not considered to be a “related party exchange.” No cashing out has occurred. Moreover, a sale of relinquished to an unrelated party and purchase of replacement property from a party is permitted if the party is also performing their own a 1031 Exchange with purchase of qualifying replacement real estate. No cashing out has occurred. Finally, a purchase of replacement property from a party is permitted if the  tax liability paid by the party is more than the tax deferred by the exchanging party. In these transactions tax avoidance is not the motivation.

As always we work hard to maximize the tax efficiency of your 1031 exchange.

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