Understanding Related Party 1031 Exchanges

One of the most elusive issues in the subject of 1031 exchanges is the so-called “related party exchange.” A related party exchange is a type of specialized 1031 exchange which has its own set of rules and guidelines. Even experienced facilitators and attorneys can have a poor grasp of related party exchanges. In this post, we will clarify these transactions so that our readers have a basic understanding of what is involved with these exchanges.

 

Basic Mechanics

 

As readers should recall, a 1031 exchange occurs when a taxpayer sells his or her real property and then acquires a replacement real property within a certain time frame. Note that the purchase/sale order can be reversed. But what happens if one of the buyers or sellers is “related,” either through kinship or corporate ownership, to the taxpayer? If this is the case, then the transaction is described as a “related party” exchange. Related party exchanges are allowed under the code, but additional rules apply.

 

Related Party Rule within Section 1031

 

The language of Section 1031 contains a special set of rules that apply to “direct” and “indirect” related party exchanges. Code Section 1031(f)(1) provides that in direct related party exchanges – i.e., exchanges in which a direct swap occurs – the acquiring party must hold the property for two years or the exchange will be disallowed. Section 1031(f)(4) further provides that if the taxpayer attempts to avoid the 2-year rule by structuring an exchange to avoid it, the exchange is disallowed. (BUT, Section 1031(f)(2)(C) limits 1031(f)4) by stating that a direct exchange that violates the 2-year rule will NOT be denied nonrecognition if the taxpayer can prove the transaction was not structured just to avoid federal income tax. And tax courts, using “substance over form) have allowed non-recognition based on this section.) Indirect exchanges involving an unrelated intermediary cannot circumvent the related party exchange rules. But as explained below, indirect exchanges only need to obey the abusive tax avoidance rule.

 

Teruya Bros. & Additional Guidance

 

The most important case involving related party rules is Teruya Bros. vs. Commissioner (2009). The Teruya Bros case involved two indirect, related party exchanges where the taxpayer essentially collaborated with a related party in such a way that produced a much better result than would have been possible otherwise. The court determined that the taxpayer ran afoul of the abusive tax avoidance rule. But Teruya Bros. made clear that indirect exchanges fall outside the 2-year rule. Indirect exchanges involving related parties are governed by the “purpose” rule only. Teruya Bros. also clarified how the court can determine if this purpose was observed.

The whole purpose of the related party rules is to prevent abusive tax avoidance. Using a “substance over form” approach, the IRS’ decision is clearly subjective. If you plan to attempt a related party exchange, consult with a qualified attorney who can help you understand these complicated rules and help guide you to avoid any entanglements with the IRS.

 

Contact the Davidson Law Firm for More Information

For more information, contact the Davidson Law Firm today by calling 501-374-9977. If you need facilitator services, we can put you in touch with 1031 Exchange Services, LLC, our partner firm.

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