1031 and related parties

Dear 1031x:  My private oil and gas company holds an option to purchase certain oil and gas working interests.  The right to exercise these options is assignable.  I am in the midst of a 1031 exchange.  I own 100% of this oil company.  I would like to acquire the same working interests as part of  my 1031 replacement property.  If  my oil company assigns its rights to exercise these options to purchase to me, and then I exercise the option, buying the working interests from a third party, will tax deferral will be maintained ?    

Dear Sir: You have asked me to explain how tax deferral under IRC section 1031 can be effected when exchanges occur  involving related parties.  You have also asked me how these rules will effect a specific fact pattern.

The IRS defines related parties as parents, spouses, children, agents of the taxpayer or entities where the same individuals control at least fifty percent of both entities. With specific regard to related parties and 1031 exchanges:

First:
Section 1031(f)(1) of the Code provides that if a taxpayer exchanges property with a related person, resulting in non-recognition of gain under the section, and within two years of such exchange the related person or the taxpayer disposes of the property received in the exchange, then the taxpayer must recognize the gain. The effective date upon which the taxpayer must recognize the gain will be the date upon which the later sale occurs.

Therefore, when related parties engage in an exchange, both parties must retain the property obtained in the exchange for two years for either of them to gain the tax deferred advantages of section 1031.

The purpose of this code section is to prevent basis shifting between related parties, for example.  Dad owns the Mayfair apartment building with value of $1M and basis of $100K.  Son own the Fairoaks apartment building with a value of $1M and a basis of $900K.   Dad receives an offer to sell Mayfair.  Instead Dad and Son 1031 exchange Mayfair and Fairoaks.  Son then sells Mayfair to buyer.  Unless two years had elapsed after the 1031 exchange between Dad and Son both parties would lose their 1031 tax deferral.

Second:
In a three party exchange where the exchanger sells the old property to a related party and buys the new property from an unrelated party, the old property should be held for two years in order to assure no recognition.   The same rational as expressed above applies here.  If the related party, now owning the old property,  immediately sold the old property they would have no gain recognition.  They would, as a practical matter, have accomplished the basis shifting prohibited by section 1031(f). (TAM 9748006)

Third:
In a three party exchange where the exchanger sells the old property to an unrelated party; the new property usually may NOT be purchased from a related party.  The IRS   treats purchase from a related person as buying from yourself and disallows tax deferral.  If you think of related parties as the same tax payer then buying from a related party does look like buying from yourself.  When you buy from yourself you start the exchange with two properties and finish the exchange with one property and cash, no exchange.  This cashing out of real estate will disallow the tax deferral. There are two exceptions to this rule:  a) The related party is also doing a 1031 exchange when he sells to you, (PLR 2004-40002), or b) the gain that the related party is recognizing is larger than the one that you are deferring. (1031)(f)(2)(C).   Under exception a) no cashing out occurs, and under except b) tax deferral is not occurring.

Applying these rules to your situation I believe that your structure will satisfy the requirements of section 1031 and that tax deferral will be achieved as you are not buying from a related party. 

 

Steve Hickox
Attorney / President

1031x.com has grown to provide many services to our clients as Castle United!
Click here:  http://www.CastleUnited.com/

1031x.com, Inc.
2120 S. Birch St.
Denver, CO 80222
303.504.0144
Toll Free 888.899.1031
Fax 303.715.1012

infox@1031xcastle.com