Previously, I discussed section 1031(f) of the Internal Revenue Code, the Related Party Rules, introduced by Congress in 1989 to prevent taxpayers from manipulating the 1031 exchange rules to achieve a favorable outcome by entering into an exchange with a party related to them.
1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—
(i) the related person disposes of such property, or
(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”
We looked at the abuse that gave rise to the Related Party Rules and at which relationships are considered related parties. This week, we’ll examine common misconceptions of and exceptions to the Related Party Rules.
Common Misconceptions
I can get around the Related Party rules using a Qualified Intermediary.
Transacting an exchange through a Qualified Intermediary (QI) who is not a party related to the taxpayer does not “cleanse” the transaction when the seller is a related party. If the QI acquires the property from a party related to the taxpayer, the abuse is present, just as it would be if the taxpayer traded directly with the related party. The catch-all provisions of §1031(f)(4) make clear that “This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.” Simply acquiring the related party’s property through the unrelated QI does not change the outcome. The IRS position on this scenario was the subject of PLR 201220012 which pertained to a taxpayer’s disposal of replacement property within the two year period. The ruling concluded since the related party did an exchange from that property into another, there was no cashing out and therefore no tax abuse.
Finally, a seldom-used exception to the requirement of both parties retaining the property for two years or more occurs in the event of the death of the taxpayer or the related person. Such an event will allow for the exchanged property being sold within the two year period while maintaining the original deferral. Taxpayers will do just about anything to avoid paying tax, but this is clearly not a strategy that anyone will want to employ.
Summary
The exceptions to the prohibitions of the Related Party Rules have in common the notion that the involvement of the related party is attributable to reasons other than allowing the taxpayer to cash out while selling a low basis property to a third party. Learn more about 1031 Related Party Rules in my original post, 1031 Tax Deferred Exchanges Between Related Parties.
Updated 7/20/2022.