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About Exeter 1031 Exchange
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1031 Exchange Related Party Issues There has been considerable abuse over the years by real estate investors who have used various "related party" strategies or techniques to defer, avoid and even evade the payment of their income tax liabilities. 1031 Exchanges have not been immune to such abuse, and the Internal Revenue Service ("IRS") has issued rules and guidelines on related party 1031 Exchange transactions to curb such investor abuse. Tax Basis Swapping The 1031 Exchange related party rules or guidelines were intended by the Internal Revenue Service to prevent real estate investors from using the 1031 Exchange to shift tax cost basis between properties owned by related parties in order to reduce the overall amount of depreciation recapture and capital gain taxes recognized and paid on the sale of a specific property. This practice, also referred to as cost basis swapping, involves the sale and exchange of property that has a low tax cost basis (and therefore a large capital gain) for property owned by a related party that has a high tax cost basis (and therefore a small capital gain) in order to reduce or eliminate the overall taxes paid by the related parties. Related Party Transactions Related party 1031 Exchange transactions occur when you sell your relinquished property to a related party or you buy your like-kind replacement property from a related party. Related party 1031 Exchanges are permitted provided you follow specific rules and guidelines issued by the Internal Revenue Service. Related party issues can also be avoided altogether if the related party relationship is eliminated prior to structuring and completing the 1031 Exchange transaction. Related parties include, but are not limited to, immediate family members, such as brothers, sisters, spouses, ancestors and lineal descendents. Related parties do not include stepparents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses. Corporations, limited liability companies or partnerships in which more than 50% of the stock, membership interests or partnership interests, or more than 50% of the capital interests or profit interests, is owned by the taxpayer is considered to be a related party. Two (2) Year Holding Requirement The taxpayer and the related party must hold the properties that each received as part of the 1031 Exchange transaction for a minimum of two (2) years. The two (2) year holding period starts running on the date of the transfer or conveyance of the last property involved in the 1031 Exchange related party transaction. The tax-deferred status of the 1031 Exchange will be disallowed and the corresponding depreciation recapture and capital gain income tax liabilities will be recognized should either the taxpayer or the related party dispose of either of the respective properties prior to the end of the two (2) year holding period. The gain or loss from such a disallowance shall be recognized as of the date of the disposition of the subject property. Exceptions to the Two (2) Year Holding Requirement The 1031 Exchange transaction will not be disallowed if either of the properties is disposed of within the two (2) year holding period where and when:
Two-Party Simultaneous Related Party 1031 Exchange Related parties who concurrently 1031 Exchange or swap properties with each other must hold the properties for two (2) years following the concurrent 1031 Exchange. Both related parties will recognize their respective depreciation recapture and capital gain income tax liabilities if either party disposes of its respective property within two (2) years after the simultaneous 1031 Exchange or transfer. Disposition (Sale) to a Related Party It is clear that a taxpayer can dispose of (sell) his or her relinquished property to a related party and acquire like-kind replacement property from a non-related party without violating the related party rules and guidelines. The related party must hold the relinquished property acquired from the taxpayer for a minimum of two (2) years, and the taxpayer must hold the replacement property acquired as part of the 1031 Exchange for a minimum of two (2) years in order to qualify for tax-deferred treatment. Acquisition (Purchase) from a Related Party However, it appears that you may not be able to dispose of (sell) relinquished property to a non-related party and acquire like-kind replacement property from a related party without recognizing depreciation recapture and capital gain income tax liabilities. Most 1031 Exchange transactions structured with the purchase of the replacement property being acquired from a related party will result in tax basis swapping, whether intentional or not. The Internal Revenue Service issued Revenue Ruling 2002-83 on November 25, 2002, which establishes its position on related party 1031 Exchange transactional structures. However, you are generally entitled to defer income tax liabilities when you purchase property from a related party and your related party is also completing their own 1031 Exchange transaction using the sales proceeds from your purchase of the related party's property, or if you can prove that the transaction did not result in an income tax basis swap (tax avoidance). Subsequent Transfer into a Grantor Trust The Internal Revenue Service has previously ruled that conveying the like-kind replacement property acquired as part of your 1031 Exchange related party transaction into a fully revocable grantor trust, of which you are the sole trustor and beneficiary, will not be considered to be a disposition of the subject property and will not result in the recognition of your income tax liabilities. Tax Avoidance or Evasion 1031 Exchanges that were structured specifically for the purpose of avoiding income tax liabilities (income tax avoidance or evasion) utilizing a related party 1031 Exchange structure will be disqualified by the Internal Revenue Service. |
