Section 1031 Related Party Rules

When conducting Section 1031 transactions with a related party the simple rule is that you can sell to a related party, but you cannot purchase from one. The IRS rationale is that the taxpayer is essentially “cashing out” or basis shifting in related party transactions.

Exchanges between related parties can be conducted under special circumstances; it requires that all parties must be exchanging.  Take the case of two brothers that wish to exchange their respective 50% interests in two properties so that they will each end up with 100% interest in just one property.  This transaction would be permissible as long as they each hold their new positions for two years beyond the year of exchange.  The IRS will track this transaction by requiring that they each file a Form #8824 in the year of their exchange and again for the following two tax years.  If either of them sell before the two + year hold period has expired, it will trigger the capital gains tax for both parties.

The other possibility is that the two brothers agree to acquire investment property from their grandfather.  Normally, a prohibited transaction under the related party rules, however, if the grandfather exchanges and acquires new property from an unrelated party with the proceeds in a Section 1031 Exchange, this will work. It still requires the filing of Form #8824 in the year of the sale and two additional tax years. Any premature sale will trigger the capital gains tax that was previously deferred.

Your related parties include the following:

• Your brothers and sisters of both whole and half blood, your spouse, parents, your children, grandparents, and grandchildren;

• An individual and a corporation when the individual owns, directly or indirectly more than 50% in the value of the outstanding stock of the corp;

• Two corporations that are members of the same control group;

• A trust fiduciary and a corporation when the trust or the grantor of the trust owns directly or indirectly more than 50% in value of the outstanding stock of the corp;

• A grantor and fiduciary and the fiduciary and beneficiary of any trust;

• Fiduciaries of two different trusts and the fiduciary and beneficiary of two different trusts when the same person is the grantor of both trusts;

• A tax-exempt educational or charitable organization and a person who, directly or indirectly, controls such organization, or a member of that person’s family;

• A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest, or profits interest, in the partnership;

• Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation;

• Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation; or

• An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.

• Two partnerships if the same persons own directly, or indirectly, more than 50% of the capital interests or profits in both partnerships, or

• A person and a partnership when the person owns, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership.

• This list is not meant to be exhaustive.  Please see IRC Section(s):  267(b); 267(c); and 707(b) and the supporting Regulations for the complete rules. It is interesting to note that these people are not Related Parties (to you): Any of your aunts or uncles; any of your cousins, any of your nieces or nephews, and any of your in-laws. While it may be enticing to structure a series of transaction to avoid the tax, be mindful of  Revenue Ruling 2002-83 that provides for “any transaction or series of transactions structured to purchase Replacement Property from a related party, will not be entitled to nonrecognition treatment.”

• Section 1031 Exchanges involving Related Parties are always problematic, but not impossible to resolve. Time and good planning will produce the desired results.