All in the Family - Related Party Exchanges

Prior to 1989, many savvy real estate owners used related entities to exchange high basis property for low basis property in anticipation of the sale of the low basis property. Since parties to an exchange receive a substituted basis in their replacement property, the high basis was shifted to the low basis through an exchange. This allowed the related parties to eliminate or reduce recognition of gain on the subsequent sale of the low basis property.

Example: Taxpayer (TP) owns a building with a value of $1,000,000 and a basis of $100,000. A related party (RP) owns land with a value of $1,000,000 and a basis of $1,000,000. An unrelated buyer wants to purchase the building. In order to avoid the gain, TP and RP exchange the building and the land. RP now owns the building with a basis of $1,000,000 (e.g. the substituted basis). RP sells the building to the unrelated buyer realizing no gain.

Section 1031 restricts exchanges between related parties to prevent (i) the perceived abuse associated with "basis shifting" in related party exchanges of high basis property for low basis property in anticipation of the sale of the formerly low basis property and (ii) basis shifting which could be used to accelerate a loss on the sale of the exchange property. The legislative history states that a related party exchange followed shortly thereafter by a disposition of either exchange property should be viewed as the "cashing out" of an investment in like-kind property, such that the original exchange should not be accorded non-recognition treatment.

Direct Dispositions

Section 1031(f) generally establishes a two-year holding period for like-kind property given or received in a like-kind exchange involving related persons. Section 1031(g) suspends the running of the two-year period during any period when an exchange party's risk of loss is substantially diminished through certain contractual arrangements, such as a put.

Although §1031(f) is relatively straightforward when dealing with direct transfers, there are a number of traps for the unwary, including the following:

A. The gain recognized may be treated as ordinary if the property is depreciable and the parties are related under IRC §1239 or 707(b)(2);

B. The 2 year period begins on the date of the last transfer that was part of the related party exchange (i.e. in a deferred exchange the date of the last transfer may be up to 180 days after the transfer of the relinquished property);

C. The 2 year period may be extended under § 1031(g) if either party enters into a contract for sale, put or similar arrangement that substantially diminishes the owner's risk of loss;

D. The term "disposition" is very broad in scope and may encompass any transfer of the property including by sale, gift, contributions to an entity, and granting of easements. It should be noted, however, that the IRS has ruled that transfers to a grantor trust are permissible; and

E. The legislative history of 1031(f) indicates that dispositions include "indirect dispositions" through changes of ownership in an entity.

Indirect Dispositions

Non-recognition treatment does not apply to any exchange which is "part of a transaction (or series of transactions) structured to avoid the purpose of" the related party rules. As was previously mentioned, the purpose of the rules is to prohibit basis shifting between related parties.

The legislative history contains an example the effect of which is to prohibit a taxpayer from acquiring replacement property from a related party in an exchange when the relinquished property is conveyed to an unrelated party. The IRS confirmed this analysis in Technical Advice Memorandum ("TAM") 9748006.

In that TAM, the taxpayer sold his relinquished property to an unrelated party, and purchased his mother's property, effectuating the purchase through a qualified intermediary. The IRS found that the exchange violated Section 1031(f) because the economic result of the series of transactions is identical to what would have occurred in a direct exchange of the taxpayer's relinquished property with his mother for her property, followed by a sale of the relinquished property by the taxpayer's mother. The use of the qualified intermediary did not correct the flaw.

Section 1031(f)(4) taints a variety of transactions where a related party sells the eventual replacement property of the taxpayer in the 2 year period, including:

A. "Reverse Starker" transactions where the replacement property is "parked" with a related party who later sells it in connection with the taxpayer's exchange;

B. Build to suit exchanges where the related party constructs and sells the replacement property in connection with the taxpayer's exchange;

C. "Warehousing transactions" where a related party buys the taxpayer's relinquished property and sells it within 2 years after the exchange (although related party will have a new cost basis and could argue that 1031(f) should not apply); and

D. "Parking transactions" where the taxpayer acquires a related party's property as a last resort in a deferred exchange.

Excepted Dispositions

Under Section 1031(f)(2), certain dispositions of property received in an exchange are not taken into account for purposes of Section 1031(f)(1). These exceptions are limited to dispositions (i) by reason of the death of either party; (ii) in a compulsory or involuntary conversion (if the exchange occurred before the threat or imminence of such conversion); or (iii) with respect to which 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.

Who is a Related Person?

Family members (siblings, spouse, ancestors, and lineal descendants);
Individual and entities, (corporations, partnerships, estates, trusts, etc.) where more than 50 percent in value of the entity is owned directly or indirectly by such individual.

Two entities, if the same persons own more than 50% of the entities.
A combination of the foregoing, based on the constructive ownership rules.
Such other relationships as described in IRC §267(b) or §707(b).