Related Parties

An exchange between related parties gets close scrutiny from the IRS. The IRS is concerned that related parties would engage in abusive basis shifting, as outlined in the legislative history:

Because a like-kind exchange results in the substitution of the basis of the exchanged property for the property received, related parties have engaged in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property in order to reduce or avoid the recognition of gain on the subsequent sale. Basis shifting can also be used to accelerate a loss on retained property. The committee believes that if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, "cashed out" of the investment and the original exchange should not be accorded non-recognition treatment. H.R. Rep. No. 386, 101st Cong., 1st Sess. 614 (1989).

To curb these abuses, the IRS established a mandatory two-year holding period for exchanges between related parties. If the exchange is between related parties, the transaction will not qualify for non-recognition treatment if either party disposes of property received in the exchange during the two-year holding period. The two-year period commences on the date of the last transfer required to complete the exchange. Gain must be recognized on each of the original transfers, as of the date of disposition of the property.

The IRS will consider making an exception to the holding period requirements in the event:

• of an involuntary conversion of one of the properties;
• of the death of the Taxpayer or the related person; or
• the Taxpayer can convince the IRS that the transaction does not have the avoidance of income taxes as one of its principal purposes.

In PLR 9926045, the IRS gave its first (and so far only) public interpretation of the exceptions contained in 1031(f). Related parties exchanged parcels of timberland. After the exchange, one of the parties intended to harvest the timber on its parcel. The IRS held that harvesting the timber would not trigger a recognition of gain under § 1031(f)(1). The IRS relied heavily on the legislative history of that section, to determine that Congress did not intend (f)(1) to apply to this type of disposition.

Related parties may structure their transaction to provide for disposal of their respective replacement properties upon the expiration of the two-year holding period. FSA
200137003.

Definition of Related Parties [NOTE: These definitions also apply to the determination of whether someone is a "Disqualified Person" for purposes of serving as a Qualified Intermediary (QI), except you must insert "10%" in place of "50%" wherever it appears.]

• Members of the same family (including spouses, ancestors & lineal descendants);
• Corporations, if part of a controlled group. (i.e., ownership of stock possessing at least 50% of the total combined voting power of all classes of the voting stock);
• An individual and a corporation, if the individual owns more than 50% of the corporation;
• A corporation and a partnership, if Taxpayer owns more than 50% of each;
• A Grantor and a fiduciary of the same trust;
• A fiduciary and the fiduciary of another trust, if both trusts have common grantors;
• A fiduciary and beneficiary of the same trust;
• A partnership and a person owning directly or indirectly more than 50% of the capital interest or profit interest of the partnership;
• A fiduciary of trust and a corporation, where more than 50% of the stock is owned directly or indirectly, by or for the trust, or by or for a person who is grantor of the trust;
• Two partnerships, if one person owns more than 50% of each;
• A person and a § 501 organization, if the person or their family control the organization;
• Two sub S corporations that are controlled by one person, directly or indirectly; or
• Two corporations where one is sub S and the other is a C corporation. 

Should the related party rules apply to every exchange that involves a related party?

The related party rules were established to stop abusive basis shifting. However, it is possible to have an exchange that involves related parties that does not result in an abusive shifting of basis. The following examples were discussed in a series of "open issues" presented by a committee of the ABA Section on Taxation to the IRS. They are suggested interpretations, without the force of a statute or regulation.

EXAMPLE 1: In a deferred exchange, the QI acquires the relinquished property and sells it to a party related to the Taxpayer, for cash. The replacement property is acquired from an unrelated party and transferred to the Taxpayer. If the replacement property was never owned by the related party, the transfer to the Taxpayer should not be affected by the related party­'s purchase of the relinquished property. The related party'­s purchase involves the creation of a new cost basis, rather than a carryover. Thus, there is no abusive shift of basis.

EXAMPLE 2: In a deferred exchange, the replacement property is owned by a related party. An unrelated party (or Qualified Intermediary) purchases the replacement property and exchanges it for the relinquished property held by the Taxpayer. This demonstrates the catch-all provisions of § 1031(f), which denies non-recognition treatment to an exchange that is part of a transaction (or series of transactions) structured to avoid the "purposes" of the related party rules. The result of this transaction is the same as if the related parties had exchanged properties with each other prior to the transfer of the relinquished property to the unrelated party.

Use of a QI does not automatically "bless" the rest of the exchange, as the Taxpayer discovered in TAM 102519-97. In that case, the Taxpayer and his mother owned investment property as tenants in common. Upon the sale of the property, the Taxpayer sought to do an exchange of his interest, while his mother wanted to purchase a residence for herself.

The Taxpayer was unable to find suitable replacement property, so he identified the property that the mother had chosen as her residence. Since the mother disposed of her like-kind property within two-years, the Taxpayer­'s exchange was disallowed. The Taxpayer unsuccessfully argued that his use of a QI brought his exchange into compliance with § 1031(f).

Miscellaneous Related Party Issues

• IRS Form 8824 must be filed for the year of the exchange and for the two-years thereafter.
• Losses are subject to the § 267 prohibition against the deduction of losses on the sale or exchange of property between related parties.
• Gain or loss is recognized as of the date of disposition, therefore there is no need to file an amended return for the year of the exchange.
• The two-year period may be suspended if the risk of loss is substantially diminished for either of the related parties (e.g. use of a "put" option). § 1031(g)(1).
• The transfer of property to a grantor trust within the two-year period does not trigger recognition of gain. PLR 9116009.