Related Party Transactions In A 1031 Exchange

Saturday, April 22, 2017

The Internal Revenue Code (IRC) defines related parties as:

  1. Husbands and wives.
  2. Lineal descendants and ancestors.
  3. Business entities controlled (50% or more) by you or a related party.
  4. Trusts or estates of which you or a related party is a beneficiary.

There are two exceptions to this rule:

  1. If the related party seller is also reinvesting the cash received in their own 1031, or

  2. If the amount of tax being paid by the related party on their sale is greater than the tax deferred by the related party buyer, then the transaction is allowed.

Related parties include:

  1. Siblings and lineal descendants or ancestors,

  2. Businesses where at least 50% ownership is vested in related individuals,

  3. Trusts in which related parties are either grantors or fiduciaries,

  4. An executor of an estate and a beneficiary of an estate!

IRC denies tax deferral to certain 1031 exchanges when related parties are involved under the rational that related parties should be treated as the same taxpayer under the tax code.

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.

Many taxpayers wish to sell a less desirable property and purchase a more suitable property from a related party, and achieve tax deferral under section 1031.  The short answer is that it cannot be done. There are extensive tax rules about related party transactions, but the main point is that the IRS looks at related parties as the same taxpayer.  When a taxpayer sells the relinquished party to an unrelated person and buys the replacement property from a related party the IRS does not consider this as an exchange.  After the entire related party seller ends up with cash. 

Planning opportunities exist for 1031 purchases from in-laws, cousins, aunts and uncles, unmarried partners none of who are considered related parties.  We have performed many 1031 exchanges between gay couples that are not considered related under federal law. Be careful what you wish for.

Example 1:

Father and son each own apartment building worth $1M. Father bought his long ago and has a low basis in his property. Son bought his recently and has a high basis in his. Father receives an offer to sell his property. Father and son swap property with each doing a 1031x. Son sells the property that he just acquired from Father. Because basis is carried forward in a 1031x son has little tax liability on the sale while Father would have had a large tax liability if he had sold it. Neither party will receive tax deferred treatment in this example unless both parties have held their property for at least two years after the swap occurs.

Example 2:

Exchanger sells his relinquished property to a related party for FMV and buys a replacement property from an unrelated party. This transaction will be given tax deferred treatment. There is no basis swapping and no reduction in investment.

Example 3:

Exchanger sells his relinquished property to an unrelated party and buys a replacement property from a related party. Because the IRS treats related parties as the same tax payer this transaction will not be given tax deferred treatment. At the start of the transaction the related parties own two properties and at the end of the transaction they own only one and have cash.

Exception B to Example 3:

Same facts but when the related party sells the replacement property to the Exchanger the related party does their own 1031x (1031 exchange) and buys a new replacement property. In this case the related parties start the exchange with two properties and end the exchange with two properties. Exchangers frequently wish to buy replacement property from a related party to complete their 1031x. Often a related party will cooperate on timing and on price making the related party owned property an easy target. Buying from a related party can also resolve co-ownership problems or estate liquidity problems. Any 1031x purchase of replacement property from a related party can lead to a disallowing of the tax deferral. However, buying from a related party who then performs their own 1031 exchange can effectively extend the time deadlines in a 1031x. Imagine buying from a related party on the 180th day of an exchange thereby allowing a new identification period and a new completion period to start for the related party doing their own exchange. It is also important to keep in mind that in-laws, aunts and uncles, nieces and nephew's are NOT related parties. This can sometimes help sidestep related party mishaps

Defer your taxes with a 1031 exchange

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