Related Party Transactions
There are specific rules if you are attempting to do a 1031 Exchange with a Related Party. The definition of related parties is a combination of sections of the tax code, Sections 267(b) and 707(b).
Who is a Related Party?
A related party is any person or entity that has some relation to the taxpayer participating in the 1031 Exchange. This can include:
- Family members, such as grandparents, parents, siblings, children and grandchildren (any lineal decendants). Relatives by marriage, aunts and uncles, cousins, nephews, and ex-spouses are not considered related.
- Entities where there is common ownership of more than 50%.
If you plan on selling property to a related party in a 1031 Exchange, there should be no concern. There have been various Private Letter Rulings allowing for this structure.
Unfortunately, if is it your desire to acquire replacement property from a related party, the IRS has ruled against the taxpayer in various cases. The IRS will normally disqualify these transactions due to the possibility of basis shifting between the parties.
To meet the requirements of the related party transaction when acquiring property from the related party, the taxpayer and the party they are acquiring from (the related party) must hold the properties that each received as part of the 1031 Exchange transaction for a minimum of two (2) years. The two (2) year holding period starts running on the date of the transfer or conveyance of the last property involved in the 1031 Exchange related party transaction. This means that the related party must also do a 1031 Exchange.
These related party rules and guidelines do not prohibit or bar any related-party transactions, but merely requires a longer holding period in order to qualify for the tax-deferred exchange treatment under Section 1031.
If the IRS determines that the intent established through their ruling is not met, 1031 Exchange will be disallowed and the corresponding depreciation recapture and capital gain income tax liabilities will be recognized.
In conclusion, a taxpayer who wishes to swap properties or sell their relinquished property to a related party should be able to structure the transaction properly, as long as the parties hold the properties for a minimum of 2 years after the transaction. But, a taxpayer wishing to purchase replacement property from a related party will normally find their exchange disqualified.
Please review IRS Private Letter Ruling 2002-83 with your tax professional should you find yourself in a situation where you would be exchanging with a related party. There are always exceptions to these rules. You should consult with your counsel or tax professional for specific guidance.