I nternal Revenue Code (“IRC”) §267(b) and §707(b) (1) defines “related parties” as any person or entity bearing a relationship to the taxpayer such as: members of the family (i.e., brothers, sisters, spouse, ancestors and lineal descendants); a grantor or fiduciary of any trust; two corporations which have members of the same controlled group or individuals; or corporations and partnerships with more than a 50% direct or indirect ownership of the stock, capital or profits in these entities.

 

Under IRC §1031, a taxpayer can exchange or “swap” properties with a related party, subject to certain restrictions; namely a two-year holding requirement. The two-year holding requirement provides that a taxpayer is entitled to enter into a tax-deferred exchange only if the taxpayer holds the replacement property for at least two years (and the related person holds the relinquished property for at least two years after the date of the last transfer in the exchange transaction).

 

This two-year holding requirement was imposed to prevent taxpayers from using exchanges to shift the tax basis between properties with the intended purpose of avoiding paying taxes.

 

There are three exceptions to the two-year holding requirement that are recognized under the IRC. These exceptions are only allowed if the subsequent disposition of the replacement property was due to: (a) the death of the taxpayer or the related party; (b) the compulsory or involuntary conversion of one of the properties (as long as the exchange occurred prior to the conversion) under IRC §1033, or (c) the taxpayer can establish that neither the exchange nor the disposition of the property was designed to avoid payment of federal income tax as one of its principal purposes.

 

If a property involved in a §1031 exchange transaction is not held for the required two-years, the exchange will still be allowed as long as one of the above exceptions is shown to exist.

 

Typically, the related party issue arises in situations where the taxpayer wants to either sell their relinquished property to a related party or the taxpayer wants to buy their replacement property from a related party. There is still some uncertainty as to whether or not these exchanges will be treated favorably by the IRS. Most tax professionals believe that an exchange will be more likely to qualify for tax deferral when the buyer of the taxpayer’s relinquished property is the related party and less successful in qualifying for tax deferral if the seller of the replacement property is the related party, unless the seller is also doing an exchange.

 

In a transaction where the seller of the replacement property is the related party, the IRS will likely view this as producing the same result as if the taxpayer exchanged properties with a related party, and the related party immediately sold the property they just acquired, thus violating the two-year holding requirement.

 

Capital 1031 Exchange Company – Related Parties