Many tax professionals misunderstood the rules governing IRC section 1031 tax-deferred exchange transactions between related parties. This is not surprising since the IRS’s intentions had been unclear. However, in December 2002 the service issued revenue procedure 2002-83 to establish its position: The guidance is clear—a taxpayer (including individuals, corporations, limited liability companies and partnerships) may sell the property it relinquishes to a related party (subject to a two-year holding period) but may not buy replacement property from a related party.
What is a related party? For tax purposes, a related party is anyone directly linked by blood or bearing a relationship to the taxpayer as described in IRC sections 267(b) or 707(b)(1). For instance an individual who owns more than 50% of a corporation or partnership is related to that entity for tax purposes. Also, a trustee and beneficiary of the same trust are deemed related.
Section 1031 says “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is to be held in equivalent manner.” Generally speaking, the basis of property acquired in a 1031 exchange is the same as the basis of the property exchanged.
Before 1989 a number of taxpayers used what they affectionately called “basis shifting” to circumvent the intent of the exchange process. In a typical basis-shifting scenario, a taxpayer wanted to sell low-basis property that would generate a high tax bill. To avoid this result, the taxpayer would select another, high-basis property with the same value it owned under a different name and tax ID number. The taxpayer then exchanged or “swapped” the high-basis property for the low-basis property. The property that was sold ended up with a high basis and there was little or no tax consequence.
To stop this type of abusive transaction, in 1989 the IRS added section 1031(f) to the code. The key element of this addition was a required two-year holding period after a transfer of property between related parties. Also included was subsection (f)(4) that says “this section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of section 1031(f).” The rationale was clear: “If a related-party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, ‘cashed out’ of the investment” and are not entitled to nonrecognition treatment.
The added antiabuse rules were similarly clear in one sense: If the taxpayer executed an exchange involving a related party, it could not dispose of the property within two years. However, the ambiguous nature of section 1031(f)(4) created other problems. What type of transaction or series of transactions would the IRS consider “structured to avoid the purposes” of the new rules? Did a distinction exist between selling property to a related party and buying property from a related party? Revenue procedure 2002-83 answers those questions and provides CPAs with clear direction for future related-party transactions.
The revenue procedure used an example of a taxpayer selling low-basis relinquished property through a qualified intermediary to an unrelated third party and then buying high-basis property through an intermediary from a related party. (The use of a qualified intermediary or accommodator was considered immaterial.) The IRS concluded that buying replacement property from a related party violated section 1031(f)(4) because it was part of a transaction structured to avoid the purpose of the related-party rules. The proposed rationale of the abusive nature of this transaction was that the taxpayer was selling low-basis property and receiving in return high-basis property owned by a related party.
This was a similar fact pattern and conclusion of tax advice memorandum (TAM) 9748006, which the IRS issued in 1997, catching many CPAs and taxpayers off guard. In this transaction, a mother and son sold property they co-owned. The mother took her portion of the proceeds and bought property she used as a primary residence. For his part the son set up a 1031 exchange, identifying three potential replacement properties. One was the house his mother had just bought. He was unsuccessful in acquiring the other two properties and subsequently acquired his mother’s home as his replacement property. The IRS surmised the son had sold low-basis property for high-basis property originating from a related party and concluded it to be a failed exchange. Some tax professionals thought the conclusion was inconsistent with section 1031(f) and did not give the memorandum much credence. But it appears the IRS wanted to make a distinction between selling relinquished property and buying replacement property from a related party.
Observation. The IRS now has clarified the ambiguous nature of related-party transactions. A taxpayer may sell the property it is relinquishing to a related party as long as it complies with the two-year holding period. However, the taxpayer may not buy replacement property from a related party. CPAs should be prudent and use caution when a related party is involved in an exchange transaction. Related parties are treated differently and have a unique set of rules. Knowing these rules should eliminate unpleasant surprises.
Prepared by Ronald L. Raitz, CCIM, president, Real Estate Exchange Services Inc., Marietta, Georgia. He serves on the board of directors of the Federation of Exchange Accommodators. His e-mail address is firstname.lastname@example.org .