IT'S ALL RELATIVE - RELATED PARTY ISSUES IN SECTION 1031 EXCHANGES
Feb, 2010
When it comes to related party issues, Section 1031 exchanges are no
different than most of tax law - fraught with peril and rather
confusing. Let's try to make some sense of it, shall we?
The crux of the matter when it comes to related party matter and
1031 exchanges is that the IRS is not a big fan of using a relative to
establish a higher basis in a low basis property through an exchange.
That is known as basis shifting, or basis swapping, and it is highly
frowned upon. And they've taken steps to ferret out abusers - Form
8824, the form on which every 1031 exchange must be reported, contains
a very specific question on Line 7: "Was the exchange of the property
given up or received made with a related party, either directly or
indirectly (such as through an intermediary)? If yes, complete Part
II." Part II then requires you to disclose a number of facts about the
transaction.
So who qualifies as a related party? Well, related
parties include, but are not limited to, immediate family members. "Up
and out," you might say: your siblings, your spouse, your ancestors and
your descendants are all related parties. Some people who are not
related parties to you are aunts and uncles, in-laws, cousins, nieces
and nephews, ex-spouses and stepparents. Also, a corporation or other
entity of which more than 50% of the ownership is owned by you is a
related party.
Let's now break down what can and cannot
be done within a 1031 exchange that involves related parties.We'll look
at two distinct scenarios: 1) Sale of the relinquished property to a
related party, and 2) Purchase of the replacement property from a
related party.
Sale of the relinquished property to a related party:
With some caveats, selling your relinquished property to a related
party is A-OK. The major caveat is that both you and the related party
must agree to hold the properties you acquire for a minimum of two
years following the exchange. If you are confident that the related
party you sell to will hold the property for those two years, and you
are confident that you will hold the property you acquire from a
non-related party for the same two years, then it is clear that this
transaction is okay with the IRS.
Purchase of the replacement property from a related party:
In most cases, you are not able to acquire your replacement property
from a related party without running afoul of the IRS and facing the
resulting tax liabilities. The primary exception to this ruling (which
was set out in Rev. Proc. 2002-83, for anyone looking for a citation)
is if the related party is also doing a 1031 exchange. The other
exception is if you can establish to the satisfaction of the IRS that
the transaction did not result in a basis swap, which would be quite
difficult to do except in the most unusual of circumstances.
To conclude, be aware that exchange transactions that involve
related parties must be well thought out and structured properly to
withstand the scrutiny of the IRS. Please contact us early in the
process if you are contemplating such an exchange so we can work
together to create a solid platform for you.