RELATED PARTY RULES

The related party rules were introduced to the Code and Regulations in 1989. Code Section 1031(f) was intended to prevent taxpayers from using exchanges under §1031 to effectively shift tax basis between properties owned by related parties, thereby allowing them to reduce the gain on the sale of one of the properties. 

For purposes of Section 1031, the definition of a “related person” or related party is any person who has a relationship to the taxpayer described in §267(b) or §707(b)(1) of the Code.  This includes:

1. Family members (siblings, spouse, ancestors, and lineal descendants);
2. An individual and a corporation, where more than 50% in value of the stock is owned directly or indirectly by or for said individual;
3. Two corporations that are part of the same control group;
4. A grantor and a fiduciary of the same trust
5. A fiduciary and a beneficiary of the same trust;
6. A fiduciary of a trust and the fiduciary or beneficiary of another trust where the same person is the grantor of both trusts;
7. A fiduciary of a trust and a corporation where more than 50% in value of the stock of which is owned, directly or indirectly by or for the trust or by or for the grantor of the trust;
8. An individual and a §501 organization (tax-exempt), if the organization is controlled by that person or that person’s family;
9. A corporation and a partnership, if the same people own more than 50% in value of the stock of the corporation and more than 50% of the capital interest or profits interest in the partnership;
10. An S-corp. and another S-corp. or a C-corp., if the same people own more than 50% of the value of the stock of each corporation;
11. A partnership and an individual who owns more than 50% of the capital interests or profits interests in such partnership, directly or indirectly;
12. Two partnerships wherein the same people own more than 50% of the capital interests or profits interests, directly or indirectly; and
13. An executor of an estate and the beneficiaries of the estate.

The most simplistic related party transaction is the direct swap between related parties.  In the direct swap scenario, neither party is required to recognize gain so long as they each hold the replacement property received for a minimum of two years. The two year time period is calculated from the date of the last transfer that is a part of the transaction. In direct swap transactions, there is no investigation into whether basis-shifting has occurred.  The transaction may be tax-motivated as long as the bright-line two year test is respected.

There are also certain exceptions to the two year holding period requirement.  These include involuntary conversion and similar circumstances, as well as transfers caused by the death of a taxpayer. An additional exception from Section 1031(f) related party rules is when a transaction has a substantial business purpose and no tax avoidance purpose. There is no specific list of transactions which qualify for the no tax avoidance exception, and the burden of proof in such a situation lies with the taxpayer; however, there are some examples in the legislative history of Section 1031(f).

Several recent Private Letter Rulings have clarified the Service’s position on family partitions which are generally direct swap transactions.  If one parcel is partitioned among several heirs then no exchange has occurred.  If multiple properties are exchanged among co-owners who have inherited property so that each heir ultimately holds fee simple title to a property rather than an undivided interest in multiple properties, an exchange has occurred. The Service has taken the position that if all heirs inherited the property at the same time, there is no basis shifting and the initial exchange will be respected regardless of the holding period after the exchange.

The next related party transaction commonly seen is the transfer of relinquished property to a related party and the purchase of replacement property from a third party.  These transactions are generally respected by the Service, and the relinquished property may be sold by the related party without regard to the two year holding period. Another recent ruling has held that these transactions may also be conducted in the form of a reverse exchange in compliance with the provisions of Revenue Procedure 2000-37.

The most heavily publicized type of related party transaction is the sale of relinquished property to an unrelated third party and the purchase of replacement property from a related party.  This type of transaction is rife with potential for abuse and the Service recently won a victory in the Tax Court with respect to these types of transactions. 

When Section 1031(f) was first adopted many practitioners where under the misperception that the rules would not apply to an exchange in which the taxpayer sold low basis property to an unrelated third party, had the proceeds transferred directly to a qualified intermediary, who subsequently purchased high basis replacement property from a related party and transferred it to the taxpayer in completion of the exchange.  In Revenue Ruling 2002-83, the Service indicated that the use of qualified intermediary to complete an otherwise disallowed transaction would not wash the transaction. The Service points out that the transaction described above nets the same result as if the related parties had exchanged their properties and then the related party had sold the low basis property to the third party. IF the transaction were recast as an exchange followed by the sale, the Service indicates it would not meet the two year rule and would have successfully allowed for basis shifting between related parties. Because of the form over substance nature of the transaction, the Revenue Ruling finds the transaction is one of a series of transactions intended to avoid Section 1031(f) and disallows the exchange.

The Service has been very particular in enforcing these rules and has recently won support from the Tax Court.  In Teruya Bros., The taxpayer sold a series of properties to a third party through the use of a qualified intermediary.  The taxpayer then instructed the qualified intermediary to purchase replacement properties from a related corporation.  The related party actually recognized more gain on the sale than Teruya Bros. would have recognized, but it had significant net operating loss carryovers that it used to absorb the impact of the tax liability.  Ultimately, no income tax was paid to the Service and the only impact of the transaction was a loss of NOL carryover to subsequent tax years for the related party.  The Tax Court ruled that the non-tax avoidance exception was applicable to the type of transaction conducted, but that in the particular fact pattern presented, the main motive was tax avoidance.  The Court held that the related party incurred no additional tax, and tax avoidance was the main motivational factor in structuring the transaction.  This decision seems to nullify the importance of tax attributes like NOL carryovers and has been appealed to the taxpayer friendly Ninth Circuit.

The main exceptions to the tax avoidance restrictions found in Section 1031 include partitions (discussed above), dispositions in a non-recognition transaction, and transactions in which no basis shifting occurs.  Teruya Bros. indicates a situation in which no basis shifting occurs, and likely would have been decided in the taxpayer’s favor, but for the NOL applied by the related party.

The disposition of property by a related party in a non-recognition event has recently been the topic of several Private Letter Rulings.  In these rulings the Service has confirmed that if the related party exchanges its property for like-kind property then the transaction will not be a tax-avoidance transaction.  As an example, if party A sells through the use of a qualified intermediary property with a $0 basis and fair market value of $150,000, and the intermediary purchases replacement property from Party B (a related party to A with a $100,000 basis in its property) for $150,000, then the tax avoidance provisions of Section 1031(f)(2) would apply.  However, if Party B sells the replacement property to A through the use of a qualified of its own and purchase replacement property for itself from an unrelated third party, then the transaction would have no tax avoidance purpose and would be respect for purposes of Section 1031. Finally, these rulings addressed the fact that some taxable boot in either exchange would not frustrate the entire exchange, but would create a tax liability to the party undertaking that particular leg of the transaction.