If you’re thinking of “beating the system” by buying from a family member or your own business entity in a 1031 exchange, be careful – you might be breaking IRS rules.
Performing a 1031 exchange can be complicated, with lots of rules to follow and a strict timeline by which your exchange must be completed. Even if you feel confident in your choice of relinquished and replacement properties, unexpected events can occur. That’s why it’s always good to have a backup plan in case your preferred replacement property falls through.
In a standard forward exchange, you can identify up to three properties (more in some circumstances) as potential replacement properties. You don’t have to ultimately purchase all three, so it’s a good idea to use all three identification slots to have backups in case your first choice unexpectedly becomes unavailable. It’s also worth considering a Delaware Statutory Trust as one of your backups, as a DST could potentially be a more stable option as a last resort.
There’s one other backup method many exchangers have considered over the years: purchasing a property from a parent, immediate family member, or a corporate entity the exchanger owns. A close relation may seem like the ideal source for a backup because their property may be offered exclusively to you in case your exchange is in danger of failing, ensuring at least one of your identified properties will definitely be available.
There’s just one flaw with this method: the IRS has thought of it, too, and there are a lot of rules that can trip you up.
IRS rules regarding related-party 1031 exchanges
The IRS has rules in place regarding related-party exchanges to prevent the practice of “tax basis swapping.” This is where a property with a high cost basis is exchanged for one with a low cost basis in order to reduce the capital gain recognized on the sale of the property.
The IRS has added provisions to Section 1031 of the tax code to stop this practice in like-kind exchanges. Section 1031(f) outlines “Special rules for exchanges between related persons” that apply to situations where a taxpayer exchanges property with a related party as part of a 1031 exchange. The rules differ depending on whether you are selling an investment property to a related party, buying a replacement property from a related party, or both.
Buying a replacement property from a related party in a 1031 exchange
If you buy an investment property from a related party in order to complete a 1031 exchange, you must then hold that replacement property for at least two years after acquisition. If you dispose of the replacement property within two years, your exchange may be taxed.
There are also rules regarding what the related party can receive in exchange for their property. It is possible to acquire a replacement property from a related party if they are selling the property as part of a 1031 exchange (more on this in a later section). If the seller is not performing an exchange and instead wishes to treat the transaction as a taxable sale, their taxable gain from that sale must be greater than your deferred gain.
This is how the IRS stops basis swapping: by ensuring that the property sale that is taxed reflects the greater tax liability of the two sales involved in the exchange. If your relative is recognizing more gain and paying more taxes on their sale than you would have recognized in a taxable sale if you were not performing an exchange, then your exchange may qualify.
As far as who qualifies as a “related person,” it is a list which includes not only family members such as siblings (half or whole), spouses, ancestors, and lineal descendants, but also any corporation or partnership where the exchanger owns more than 50%, two corporations controlled by the same group, the fiduciary of a trust and the beneficiary of the trust, and other types of relations.
What about selling a relinquished property to a related party?
When selling investment property to a related party as part of a like-kind exchange, the two-year rule still applies, but only to the replacement property acquired by the exchanger. Regardless of whether your replacement property is acquired from a related party or from an outside party, you still must hold it for at least two years if you sell your relinquished property to a related party.
However, there is no two-year requisite holding period for the relinquished property acquired by the related party. This can potentially make selling to a related party as part of a 1031 exchange much easier than buying from a related party.
Are there situations where it is possible to perform a related-party exchange?
The IRS has issued some additional rulings that clarify individual situations where a related-party exchange may be permissible. Revenue Ruling 2002-83 says that a taxpayer who transfers relinquished property to a QI in exchange for replacement property formerly owned by a related party is not entitled to nonrecognition treatment under Section 1031(a) of the IRC if, as part of the transaction, the related party receives cash or other non-like kind property for the replacement property.
Some taxpayers have mistakenly thought that because they are using a Qualified Intermediary, the QI eliminates the connection to the related party, but this is not the case. Even though your transactions are technically with the QI, the property was still owned by a related party, and therefore the rules regarding related-party exchanges will apply.
One situation where it is possible to buy from a related party is when the related party is also performing a 1031 exchange and acquires like-kind replacement property. Both parties would need to maintain ownership of their replacement properties for at least two years after acquisition.
Another ruling, FSA 2001137003, allows for the taxpayer to acquire a replacement property from a related party if the taxpayer and the related party are involved in a property “swap,” and each holds their property for at least two years. This ruling covers simultaneous exchanges, which can qualify if both you and your relative hold your received properties for the two-year period.
There are certain rare exceptions to the two-year rule: if the disposition of the replacement property occurs “after the earlier of the death of the taxpayer or the death of the related person,” it may be acceptable to dispose of the replacement property within two years.
There is also an exception if “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.”
The situations for these exceptions are rare, and it shouldn’t be assumed that your exchange will qualify, even if you feel you can prove the exchange wasn’t being performed to avoid taxes.
How can you know if your exchange will qualify for 1031?
You may wonder if your particular situation can meet the requirements for an allowable related-party exchange. Because a failed exchange can result in a greater immediate tax burden and a reduction in capital available for reinvestment, it is always prudent to consult tax and legal advisers regarding your specific situation.
1031 rules are always changing, which is why it’s important to work with an experienced Qualified Intermediary that can help you navigate the particulars of your exchange and avoid running afoul of IRS rules. JTC has experience with all types of 1031 exchanges, including reverse exchanges and other complex scenarios. If you want to make sure you’re doing the utmost to ensure a successful exchange without violating 1031 rules, get in touch with a JTC representative today.