1031 Exchange Rules: Related Parties

The Internal Revenue Code Section 1031 was changed to reflect exchanges between related persons in the Omnibus Budget Reconciliation Act of 1989. Subsequent additions were made in the early 1990s that further refined related party 1031 exchange transactions. The reason for the regulations was to prohibit basis shifting between related parties. Basis shifting is when a property with a high adjusted basis is exchanged for a property with a low adjusted basis or a strategy of interdependent steps to avoid or diminish federal income taxes.

Related Party Definition

A related party is defined as any family member of the exchangor including:

  • siblings
  • spouse
  • parents
  • lineal descendants
  • grandparents
  • grantor and fiduciary
  • fiduciary and a beneficiary of the same trust
  • executor and beneficiaries of the estate

Other related parties include the exchangor and a corporation or partnership where more than 50 percent in stock value is directly or indirectly owned by or for exchangor, or a corporation and a partnership if the same exchangors own more than 50 percent in outstanding stock value of the corporation and more than 50 percent of the capital or profit interest in the partnership.

Selling to Related Party

The disposition of a property to a related party is permissible even if the related party intends to sell the property it acquired from taxpayer within two years per Private Letter Ruling (PLR) 200709036 and PLR 200712013. The property must be held for two years in exchanges between two-party exchanges between related parties and where related party sells replacement property to taxpayer and related party then completes its own exchange.

There are exceptions to the two year rule permitting the sale and not resulting in a failed exchange including:

  • Disposition of property following the exchangor’s or related person’s death
  • Disposition in a compulsory or involuntary conversion in a Section 1033 given the threat of imminence occurred after the exchange
  • Purpose of disposition is not the avoidance of federal income tax.

Acquiring from a Related Party

The exchangor may acquire the replacement property from a related party given the related party is also initiating a 1031 exchange and not cashing out. Do not misinterpret this as the exchangor exchanging property with an unrelated party, acquiring replacement property from related party and holding for two years. Whenever a related party is involved in a 1031 exchange, the exchange must satisfy the non-tax avoidance motive of whether a low tax basis was shifted into high basis property.

Tax Avoidance of Step Transactions

Planned transactions to circumvent related party rules may be considered a step transaction resulting in the 1031 exchange being disallowed. In Kornfeld v. C.I.R., 10th Circuit 1998, the step transaction doctrine was applied to disallow a related party exchange because the taxpayer engaged in a series of steps in addition to the exchange to turn an expenditure for nondepreciable land into depletable, stepped up basis in oil and gas leases.

On Form 8824, Like-Kind Exchanges, line 7, The Internal Revenue Service (IRS) asks whether the property of the exchange was sold to or acquired from a related party. Form 8824 instructions state that if the taxpayer can present to the satisfaction of the IRS, that tax avoidance was not the primary purpose of the exchange, an explanation should be included when filing the form. Otherwise, do not report the transaction on Form 8824 and consider the 1031 exchange disallowed. Recent related party Tax Court cases to consider include Teruya Brothers, Ltd. & Subsidiaries and Ocmulgee Field, Inc.

We Can Help 

Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.

Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.

1031 Exchange Rules: Same Taxpayer Requirement

Buying and selling property with a 1031 exchange can be a very lucrative investment when done properly. Simply understanding the market, however, is not enough to ensure turning a profit. An investor must also understand the various tax consequences involved in real estate transactions. In the normal course of business, capital gains taxes are incurred whenever a taxpayer sells property and realizes a gain on the sale. One method that can be used to defer the payment of capital gains taxes is to enter into a Section 1031 Exchange instead of a traditional sale. In essence, a 1031 exchange involves the taxpayer relinquishing one property and acquiring a replacement property of “like-kind” within 180 days of the relinquishment. One of the rules of a 1031 exchange requires the same taxpayer to complete both ends of the exchange. While this may sound simple enough, there are some circumstances where the identity of the “taxpayer” for purposes of the exchange can become complicated.

Same Taxpayer Requirement

A straightforward exchange involving a single taxpayer on both ends of the transaction clearly meets the same taxpayer requirement; however, not all transactions are that straightforward. Spouses, business entities, and trusts all buy and sell property as well. In addition, a taxpayer can die or otherwise become incapacitated in the middle of a 1031 exchange. Likewise, a business entity can change form or structure in the middle of an exchange The Internal Revenue Service, or IRS, has clarified some of these situations as they pertain to a 1031 exchange.

Death of Taxpayer and Spouses

If a taxpayer dies during the completion of a 1031 exchange, the taxpayer’s estate may complete the transaction and still receive the benefit of the exchange. Transactions entered into by a husband and wife sometimes present issues as well. In community property states, for example, a taxpayer may create a barrier to Section 1031 Exchange treatment without realizing it. If, for example, title to the relinquished property was originally held by only one spouse, but the other spouse is included on the title to the replacement property because of the community property laws, the transaction will not be recognized by the IRS as a 1031 exchange. In the eyes of the IRS, the spouse who owned the relinquished property has now gifted half of the replacement property to his or her spouse, meaning that the same taxpayer did not complete both ends of the transaction.

Another issues that sometimes arises with transactions involving an individual or a married couple is when a lender requires the formation of a separate business entity, such as a limited liability company (LLC). Revenue Procedure 2002-69 specifically addresses this issue as it applies to a married couple by treating a husband and wife LLC as a disregarded entity if the couple chooses to treat it as such for federal tax purposes. In practical terms, this means that a single taxpayer LLC, or a husband and wife LLC, may qualify to take title to the replacement property without violating the “same taxpayer” rule.

Grantor Trusts

Trusts create another potential problem. Revocable trusts can relinquish title or take title without a problem in most cases because the property is still legally owned by the grantor, or the individual completing the exchange. An irrevocable trust, however, can create a problem because the property is not legally owned by the grantor once placed in the trust. In order for this scenario to qualify, the trust itself will have to take title to the replacement property as well as relinquish title to the original property.

Corporations

Business entities can participate in a 1031 exchange; however, the exact same entity that relinquishes the property must take title to the replacement property. In Chase v. Commissioner, 92 T.C. 874 (1989), a partnership was involved in the exchange of an apartment complex. The complex was originally held by the partnership, but two of partners transferred ownership in contemplation of the sale to them as individuals. The replacement property was then titled in their names as well. Although the partners attempted to structure the transaction in a way that would meet the 1031 exchange requirements, the court held that the substance over form doctrine applied and did not allow Section 1031 treatment. In other private rulings, business entities that have changed hands or structure throughout the exchange process have been found eligible for Section 1031 treatment. The specific facts of the exchange are very important when a business entity changes form or structure during a 1031 exchange transaction when determining eligibility.

To learn more about when a 1031 exchange makes sense, click here for a complimentary eBook on “Ten Reasons Why a 1031 Exchange Makes Sense.”

Aircraft 1031 Exchange: Fly-Away Exemption

Fly-Away ExemptionIn an aircraft 1031 exchange, an aircraft or engine held for productive use in a business or for investment sold and acquired for an aircraft or engine of equal or greater value effectively defers the capital gain and recaptured depreciation taxes triggered by the sale. The old aircraft can be sold first followed by the purchase of the replacement aircraft, or as is typically is the case in a reverse exchange, the replacement aircraft may be acquired first followed by the selling of the old or relinquished aircraft within 180 calendar days. General Asset Class 00.21 of Revenue Procedure 87-56 classifies “airplanes (airframes and engines), except those used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines)” as like-kind.

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Section 1031 Exchange: Converting Rental to a Primary Residence

Under the normal Internal Revenue Service, or IRS, code regulations you are required to pay capital gains taxes when you sell a property and realize a profit. Although the rate at which capital gains are taxed fluctuates, it is typically rather high given federal, possibly state capital gains and recaptured depreciation taxes. This tax can quickly eat away at the gain you realized on the sale of an investment. One option that allows you to defer the payment of capital gains taxes is to enter into a Section 1031 exchange instead of a traditional sale. In some limited circumstances, converting a rental to a primary residence after the exchange has been completed may be allowed eliminating the majority of the gain via the $500,000/$250,000 exclusion.

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1031 Exchange Rules Insight

1031 RuleInternal Revenue Code Section 1031 has many 1031 exchange rules that start with the code itself: “No gain or loss is recognized when property held for productive use in a trade, business or investment is exchanged for property held for productive use in a trade, business or investment.” A 1031 rule is to hold the property for the proper intent – or not for predominant personal use. Without proper intent, the 1031 exchange is not eligible for consideration.

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1031 Exchange Identification Rules

1031 Exchange Identification RulesPursuant to Section 1031(a)(3) of the Internal Revenue Code, replacement property received in a 1031 exchange is not considered like-kind to the relinquished property if the replacement property is not identified within the replacement property identification period of forty-five days post closing on the relinquished or old property. 1031 exchange identification rules are polar, implying there can be no post dating of the identification. Both the 45th and 180th day milestones can be extended given written authorization from the Internal Revenue Service due to Presidentially declared disasters such as hurricanes, tornadoes, floods and fire or military service in a combat zone.

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