Though I do not necessarily style myself as a perennial “Jeopardy” contestant, I consider myself something of a history buff. I enjoy reading up on a variety of historical topics whenever I have a chance, and since I’m in real estate, I often read up on real estate history. One of the most common themes I’ve noticed is the transferring of property between people in the same family.
This has been a major priority for people. Throughout history, a number of different mechanisms have been created to help keep a property in a family. For instance, in the feudal era, the custom of primogeniture was used to ensure that the oldest son inherited real estate following the death of the father of the family. Primogeniture has been abolished for centuries—in the U.S. it was abandoned around the time of the American Revolution—but even today, people are very much concerned with passing on their property to family members.
Of course, reading about this history naturally brings me back to my area of specialization. The law of 1031 exchanges provides guidelines for exchanges that involve “related parties.” Under current law, you are able to engage in 1031 exchanges with related parties on a limited basis. The reason for these limitations is not so much about promoting equality as it is about preventing tax avoidance. For the most part, the current law is shaped to ensure that you and other investors are not able to avoid or eliminate tax consequences by working with related parties.
Let’s get better acquainted with the related party rules governing 1031 exchanges by looking at how the term “related party” is defined and then examining some of the limitations that you have to work around.
Defining a “Related Person” in a 1031 Exchange
In everyday life, the term “related person” is used in a pretty straightforward manner, and most people probably think they have a good grasp on what this term means. But under the law, things are a bit more complicated.
In 1031 exchanges, the term “related person” is defined by Internal Revenue Code (IRC) section 267(b) and section 707(b)(1). As you’ll notice, the definition includes not just individuals who have a blood connection to the taxpayer but also to entities controlled by people who have a blood relation.
Under the relevant sections of the IRC, a “related person” refers to the following:
- Members of a family (this includes full and half siblings, your spouse, ancestors, and direct lineal descendants).
- A corporate entity, which has more than 50 percent of its outstanding stock owned by a family member.
- A grantor and a fiduciary of a common trust.
- A fiduciary and a beneficiary of a common trust.
- Various other corporate entities (such as IRC section 501 organizations, executors, and beneficiaries of a common estate).
Altogether, the rules prohibit you from conducting an exchange with quite a few corporate entities, and the rationale for this is primarily to prevent what the IRS sees as inappropriate basis shifting. As we’ve explored before, your tax basis can be altered during the course of a 1031 exchange; the IRS (and the judiciary) has chosen to limit 1031 exchanges involving related parties because of the suspicion that many people would use 1031 exchanges solely to shift tax bases and avoid the eventual recognition of gain on the sale of one of the properties.
In other words, the IRS believes that related party transactions would inevitably lead to tax avoidance, so such transactions have been greatly limited.
IRS Revenue Ruling 2002-83: Guidelines on Related Party 1031 Exchange Transactions
Though the rules regarding related party transactions are pretty tough, you are still permitted to conduct such transactions under certain circumstances. The language of section 1031 and IRS Revenue Ruling 2002-83 provide guidance regarding the permissibility of related party exchanges. Under subsection 1031(f), you may either sell your relinquished property to a relative or acquire a replacement property from a relative provided that the property, in either case, is not sold or otherwise disposed of within two years.
So, in practice, if you sell a relinquished property to a related person—say, a brother or sister—and then that person turns around and sells the relinquished property six months later, this secondary sale would bar the original transaction from receiving 1031 treatment. Subsection 1031(g) provides exceptions to this two-year holding rule. But, in general, it’s important to keep this two-year holding period in mind whenever you involve a related party in your exchange.
Ruling 2002-83 further qualifies things by disallowing 1031 treatment in cases where a taxpayer acquires a replacement property formerly owned by a related person and the related person receives cash or other personal property in the transaction. The obvious impact of this ruling is to severely limit related party transactions involving the acquisition of replacement property.
Even though the related party rules may appear stifling, the truth is that these laws have been established for the betterment of our society. As long as you’re not aiming to engage in avoidant basis shifting transactions, you’re not likely to be adversely affected at all.
At CWS Capital Partners, we’re very familiar with the related party rules and would be more than happy to help you navigate these rules should you ever need to deal with them in your 1031 exchange.
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