June 2007

1031 Exchanges and Related Parties

What is a related party exchange?

A related party exchange is a 1031 exchange where either the buyer of the relinquished property or the seller of the replacement property (or both) is considered “related” to the investor doing the exchange.  If either the buyer of the relinquished property or the seller of the replacement property is considered a related party, there are special rules and restrictions on the ability to defer tax in a 1031 exchange. 

What is a related party? 

“Related party” has a special meaning in tax law.  For Section 1031 purposes, a related party includes certain family members, such as spouses, brothers, sisters, ancestors (such as parents and grandparents) and lineal descendants (such as children and grandchildren).  Related parties also include, for example, a corporation or partnership and a person who owns more than a 50% interest in the corporation or partnership.  Other parties can be considered related parties.  For a thorough list, see Internal Revenue Code Sections 267(b) and 707(b)(1). 

“Selling” to a related party

When the investor wants to sell the relinquished property to a related party it can be acceptable, but it gets tricky, based on your transaction. You can "swap" property with a related party, as long as the investor holds the replacement property acquired in the exchange for at least two years, and the related party holds the relinquished property for at least two years, and there is no basis shifting.  If either party transfers their acquired property within two years of the exchange, the investor’s exchange is disqualified.

         However, recent IRS private letter rulings seem to allow Exchangors more latitude when the "buyer" of the property relinquished by the taxpayer, is not the "seller" of the replacement property. PLR's 200712013 and 200709036 both allow, in different circumstances, related "buyers" of relinquished property to acquire from an Exchangor and sell the acquired property to other parties within two years, if the buyer was not also transferring property to the Exchangor. This new latitude could be very helpful to investors who are, or are related to developers or property dealers.  

“Buying” from a related party

If an investor wants to buy the replacement property from a related party, it is far less likely that the exchange will result in the deferral of tax.  During the last several years, the IRS has issued several rulings which have disqualified exchanges when the investor was buying replacement property from a related party. 

There is one exception to this general rule that has been approved in two private letter rulings (PLR 200440002 and PLR 200616005).  In these rulings, the investors acquired replacement properties from related parties, and the related parties were also doing tax-deferred exchanges.  Both parties to each exchange stipulated that they would hold their replacement properties for at least two years.  In both rulings, the IRS held that the investor’s exchange was valid, since there was no “cashing out” by the related party.  In the second ruling, the IRS upheld the exchange, despite the fact that the investor received cash in addition to his replacement property.

What should I do?

Before doing a related party exchange, it is important to discuss the exchange with your tax advisor.