Exchanging with a Related Party
Exchanges between related parties are allowed but the Exchanger must follow specific rules before the exchange will qualify for tax deferral. Related parties are defined in IRC §267(b) and §707(b)(1) as any person or entity bearing a relationship to the Exchanger, such as members of a family (brothers, sisters, spouse, ancestors and lineal descendants); a grantor or fiduciary of any trust; two corporations which are members of the same controlled group or individuals; and corporations and partnerships with more than 50% direct or indirect ownership of the stock, capital or profits in these entities. Under IRC §1031(f) it is clear that two related parties, owning separate properties, may “swap” those properties with one another and defer the recognition of gain as long as both parties hold onto their replacement properties for two years following the exchange. This rule was imposed to prevent taxpayers from using exchanges to shift the tax basis between the properties with the intended purpose of avoiding paying taxes.

The more typical related party exchange scenarios have the Exchanger using a Qualified Intermediary to create the exchange with either a related party buyer who purchases the Exchanger’s relinquished property or a related party seller from whom the Exchanger acquires the replacement property. Exchanges in which the seller of replacement property is the related party are less likely to qualify for tax deferral unless the related party seller also does an exchange. Under Rev. Rul. 2002-83, exchange treatment will be denied to an Exchanger who, through a Qualified Intermediary, acquires replacement property from a related party seller, if the related party seller receives cash or other non-like-kind property, regardless of whether the Exchanger holds the replacement property for the requisite two years. The IRS will generally view this latter transaction as yielding the same result as if the Exchanger swapped properties with a related party, and then the related party immediately sold the property acquired, violating the two-year holding requirement. Exceptions to the two-year holding period are allowed only if the subsequent disposition of the property is due to (a) the death of the Exchanger or related person, (b) the compulsory or involuntary conversion of one of the properties under IRC §1033 (if the exchange occurred before the threat of conversion), or (c) the Exchanger can establish that neither the exchange nor the disposition of the property was designed to avoid the payment of federal income tax as one of its principal purposes. In fact, under IRC §1031(f)(4) a related party exchange will be disallowed if it “is a part of a transaction (or series of transactions) structured to avoid the purposes of the related party provisions.” It is also important to note that under IRC §1031(g) the two-year holding period is “tolled” for the period of time that (a) either party’s risk of loss with respect to their respective property is substantially diminished because either party holds a put right to sell their property, (b) either property is subject to a call right to be purchased by another party, or (c) either party engages in a short sale or any other transaction.

In PLR 200440002 the IRS ruled that §1031(f) would not trigger gain recognition in a series of exchanges involving two related partnerships that used an unrelated Qualified Intermediary since neither related party was cashing out of their investment in real estate and each related party represented that they would hold their replacement property for the required two years following their exchange. In the transaction, Partnership A sold their relinquished property to an unrelated third party buyer and purchased their replacement property from Partnership B, a related party. Partnership B then completed their exchange by purchasing replacement property from an unrelated third party seller. Upon completion of the two exchanges each party owned like-kind property and neither party received cash or other non-like kind property (other than boot received in the exchange) in return for the relinquished property. In the IRS analysis §1031(f)(1) did not apply because the Qualified Intermediary was an unrelated party, and §1031(f)(4) and Rev. Rul. 2002-83 also did not apply because the series of transactions were not set up to avoid the purposes of §1031(f). The IRS reached the same conclusion in PLR 200616005 with similar facts, except that Trust acquired Building 2 from related party S Corporation and planned to acquire additional replacement property from unrelated seller(s), or recognize boot only in the amount of cash received. The IRS permitted exchange treatment as long as Trust held Building 2 and S Corporation held its replacement property recieved in exchange for Building 2 for two years.

The Tax Court confirmed the IRS position in Rev. Rul. 2002-83 that the related party rules of §1031(f) cannot be avoided by interposing an unrelated Qualified Intermediary and that these types of related party transactions are within the re- characterization rule of §1031(f)(4). The Tax Court denied exchange treatment, not withstanding, that there was no basis shifting between the related parties, because it found that a principal purpose of the transaction was the avoidance of income taxes. Teruya Brothers, Ltd., 124 T.C. No. 4 (2005).