1031 Exchange Related Party Rules: Exceptions and Misconceptions

Previously, I discussed section 1031(f) of the Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code , the Related Party Rules, introduced by Congress in 1989 to prevent taxpayers from manipulating the 1031 exchange rules to achieve a favorable outcome by entering into an exchange with a party related to them.

1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—

(i) the related person disposes of such property, or

(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”

We looked at the abuse that gave rise to the Related Party Rules and at which relationships are considered related parties. This week, we’ll examine common misconceptions of and exceptions to the Related Party Rules.

Common Misconceptions

I can get around the Related Party rules using a Qualified Intermediary.

Transacting an exchange through a Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary (QI) who is not a party related to the taxpayer does not “cleanse” the transaction when the seller is a related party. If the QI acquires the property from a party related to the taxpayer, the abuse is present, just as it would be if the taxpayer traded directly with the related party.  The catch-all provisions of §1031(f)(4) make clear 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.”  Simply acquiring the related party’s property through the unrelated QI does not change the outcome. The IRS position on this scenario was the subject of Revenue Ruling 2002-83.

I looked it up and discovered it’s ok as long as I hold the replacement property for two years.

Many people, including professional advisers, see the two year holding exception to the application of the related party rules and believe that, should the taxpayer acquire replacement property from a related party and hold the property for at least two years, the prohibition is nullified.  Unfortunately, this exception only applies if both the taxpayer and the related party hold the respective properties received in the exchange with one another for a minimum of two years. 

In a more typical related party scenario, the taxpayer’s relinquished property is sold to a third party and the replacement property acquired from a related party.  Since they are not exchanging with one another, the exception by its terms does not apply.  The related party cannot hold the taxpayer’s relinquished property since that property was transferred to a third party buyer.  Only in the very narrow instance in which two related parties are exchanging with one another and they each hold the properties for two years or more does this exception apply.

Are there any other exceptions to Related Party Rules?

As indicated above, the two year holding exception has limited applicability, applying only to exchanges between taxpayers who receive (and hold) each other’s property. Under this exception, if the properties are held for a minimum of two years, there is a presumption that the trade was motivated by reasons other than “abusive basis shifting.”

Another exception, under Section §1031(f)(2)(C), provides for an earlier than two year disposition of a property that is part of a related party transaction. This section states that the transaction will not be disqualified if, “with respect to which it is established to the satisfaction of the [Treasury] Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.”  Most exchanges involve tax deferral so it is difficult to make this case.  There have, however, been favorable IRS rulings in which family members exchanged undivided interests in several properties in order to allow each to own a whole. This is a perfect example of this exception.

An additional exception is based upon a series of private letter rulings beginning with PLR 201220012 which pertained to a taxpayer’s disposal of replacement property within the two year period.  The ruling concluded since the related party did an exchange from that property into another, there was no cashing out and therefore no tax abuse.

Finally, a seldom-used exception to the requirement of both parties retaining the property for two years or more occurs in the event of the death of the taxpayer or the related person.  Such an event will allow for the exchanged property being sold within the two year period while maintaining the original deferral.  (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s will do just about anything to avoid paying tax, but this is clearly not a strategy that anyone will want to employ.

Summary

The exceptions to the prohibitions of the Related Party Rules have in common the notion that the involvement of the related party is attributable to reasons other than allowing the taxpayer to cash out while selling a low basis property to a third party. Learn more about 1031 Related Party Rules in my original post, 1031 Tax Deferred Exchanges Between Related Parties.

Updated 7/20/2022.