IT'S ALL RELATIVE -- RELATED PARTY ISSUES
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 matters 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, unless you own more than 50% of a corporation or other entity, it is not a related party to you.
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) 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.
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