A taxpayer who wishes to avoid paying capital gains tax on realized gain from the sale of property may be able to do so by entering into a Section 1031 Exchange in lieu of a traditional sale. If a transaction qualifies for Section 1031 treatment any capital gains tax that would otherwise be due is deferred. Even if a transaction meets all of the other requirements for a Section 1031 Exchange the transaction may not qualify for deferral of gain if the parties involved in the transaction were “related parties” (as defined by the Internal Revenue Service) and the property involved in the transaction was disposed of within the two year period following the exchange.
Related Party
Reverse 1031 Exchange with Multiple Related Parties
In an effort to defer the payment of capital gains taxes, a taxpayer may choose to enter into a Section 1031 Exchange in lieu of a traditional sale of property. A Section 1031 Exchange may be used by a corporate entity as well as by an individual taxpayer; however, the rules for qualifying a transaction for a 1031 Exchange become more complicated as the entities involved become more complex. In IRS PLR 201242003, the IRS considered whether Section 1031 applies in a transaction in which the taxpayer and a related party both entered into separate qualified exchange accommodation agreements to park the same property held by a single exchange accommodation titleholder.
1031 Exchange Rules: Disqualified Person
When a taxpayer sells a property, capital gains taxes are typically due on the realized gain from the sale. One option that many taxpayers utilize to avoid the immediate payment of capital gains taxes is to enter into a Section 1031 exchange instead of a traditional sale. Transactions that qualify for Section 1031 treatment allow the taxpayer to defer the capital gains taxes due on the realized gain. The basic premise of a 1031 exchange contemplates relinquishing the original property in exchange for a replacement property. The properties exchanged must be of “like-kind” and the entire transaction must be completed within a specified time period.
Constructive Receipt
In addition, a 1031 exchange transaction will be disqualified if the taxpayer actually or constructively receives money, or non-like-kind property, before the taxpayer actually receives the replacement property. The Internal Revenue Code allows for four safe harbors options to ensure that this requirement is met, including the use of a Qualified Intermediary. By using a Qualified Intermediary, the taxpayer can be assured that he or she will not be in actual or constructive possession of the proceeds in violation of the rules for the exchange. In order to take advantage of the Qualified Intermediary safe harbor provision, the person or entity that acts as the Qualified Intermediary must not be a “disqualified person” as defined by Treas. Reg. §1.1031(k)-1(k).
Disqualified Person
For purposes of a Section 1031 exchange, a disqualified person is someone who is considered an agent of the taxpayer at the time of the exchange. Family members, or related persons, of a disqualified person are also disqualified. 1031 exchange rules provide examples of some situations where the Qualified Intermediary could be considered an agent of the taxpayer including, “a person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties in a like-kind exchange.”
The Regulations further define a disqualified person by clarifying that “services to the taxpayer with respect to exchanges intended to qualify for non–recognition of gain or loss under section 1031, and routine financial, title insurance, escrow, or trust services for the taxpayer by a financial institution, title insurance company, or escrow company, are not taken into account.” Finally, entities that are controlled by the taxpayer are also disqualified. For purposes of a 1031 exchange only, this includes corporations, partnerships, and any other entity that the taxpayer, or a related party, owns either directly or indirectly, more than a 10 percent interest.
Financial Institution
An example of how the rules regarding disqualification of a Qualified Intermediary, can be found in Private Letter Ruling 200630005. In that fact pattern, a specialty finance company wished to expand its services through a subsidiary company owned wholly by the primary entity. The subsidiary would be used as a Qualified Intermediary for transactions entered into by the primary entity. The Internal Revenue Service concluded that the primary “is a financial institution and the making of loans to customers, including loans to finance the acquisition of replacement property in a like-kind exchange where (the subsidiary) is the qualified intermediary, constitute routine financial services. The primary’s sale, or offering for sale, of properties that it owns as replacement property in a like-kind exchange utilizing the subsidiary QI services makes neither the primary nor the subsidiary, the agent of a customer utilizing their services in a like-kind exchange, so long as the finance company does not act as the taxpayer’s real estate agent or broker.”
If you are considering a 1031 exchange and have questions about whether your transaction may include a disqualified person, contact our office for a complimentary consultation or click here to ask a question.
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: 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.