In a 1031 exchange, the exchangor is deferring the federal and state capital gain and depreciation recapture tax on the sale of real property held in a business or investment when real property of equal or greater value is replaced within 180 calendar days of the initial closing. The tax deferral postpones the tax until the replacement property is sold. If another 1031 exchange is initiated, the tax is deferred. There is no limit to the number of 1031 exchanges an exchangor or taxpayer can initiate. The benefit of the tax deferral is the use of those otherwise paid out tax dollars as additional working capital towards the replacement property purchase. The 1031 exchange premise is that the economic position of the exchangor has not changed. The exchangor has not received cash or reduction in debt or benefit other than exchanging one asset for another.
Related Party
A 1031 exchange is subject to a number of rules that if not satisfied will likely result in the Internal Revenue Service overturning the tax deferral, resulting in a penalty, interest on the tax deferred, tax payment and the resources to respond to the audit. One of those rules is when the exchangor sells the relinquished or buys the replacement property from a related party.
Section 1031(f) of the Internal Revenue Code addresses related party exchanges. In general, a related party exchange where the property involved in the exchange is disposed of within two years after the exchange does not qualify for non-recognition of gain; however, Section 1031(f)(2)(C) does not allow non-recognition of gain if “it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.” Section 1031(f)(4) goes on to state that “This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.”
Property can be acquired from a related party given the related party is also initiating a 1031 exchange and not cashing out. If the seller can meet the non-basis shifting exception that the property basis is as low or lower than the exchangor’s basis in the exchangor’s relinquished property, then the related party transaction is acceptable.
In order to avoid triggering the “related party” prohibition, exchangors use a Qualified Intermediary, or QI, to facilitate the 1031 exchange. By doing so the exchangor technically avoids entering into a related party exchange; however, the facts and circumstances of the transaction may then trigger Section 1.1031(f)(4) and lead to non-recognition of gain nonetheless.
The purpose of prohibiting related party exchanges is to prevent exchangors from being able to use Section 1031 to shift the basis in property and then “cash out” shortly after the exchange. Prior to the implementation of Section 1031(f), related parties would often exchange a high basis property for a low basis property and then sell the low basis property for substantial gain without being required to pay capital gain taxes on the realized gain.
A related party is defined as any person or party, including entities that have a relationship to the exchangor described in Section 267(b) or Section 707(b)(1) of the Internal Revenue Code, including the following partial list:
- Members of the same family (siblings, spouse, ancestors and lineal descendants)
- Corporation where more than 50 percent of the value of the stock is owned directly or indirectly by or for one particular individual
- Two corporations that are in the same controlled group
- A grantor and a fiduciary of any trust
- A corporation and a partnership if the same person or persons own
o More than 50 percent in value of the outstanding stock of the corporation, and
o More than 50 percent of the capital interest or profit interest in the partnership
Understanding the parties involved in the exchange is an important aspect of every 1031 exchange; the lack of understanding could very well undermine the tax deferral. If you have a related party question, click on the button below to ask the Certified Exchange Specialist®.
