IRS Clarifies Related-Party Rule in 1031 Exchanges
Last December, the Internal Revenue Service
published Revenue Ruling 2002-83, which clarifies its position on
taxpayers buying replacement property from related parties under
Internal Revenue Code Section 1031. Due to the considerable confusion
about such exchanges, real estate professionals should welcome this
ruling as it helps them better advise clients engaging in these
History of Related-Party Exchanges
related party is a family member, such as a spouse, ancestor, or lineal
descendant, or one who is defined as related under IRC Section 707(b)
or 267(b). For example, an individual is considered related to an
entity for tax purposes if he owns more than 50 percent of that entity.
Also under this definition, an estate's executor is deemed related to
the estate's beneficiaries.
Historically, taxpayers bought and
sold property from related parties with no specific restrictions. Over
time, the IRS discovered that many related-party transactions were
executed to shift basis, giving taxpayers an advantage when disposing
To understand basis shifting, consider a taxpayer
owning more than two properties who decides to sell a low-basis
property. To avoid the steep tax consequences of the low-basis property
sale, he selects one of his higher-basis properties and contributes it
to a new corporation for 100 percent of the stock. The taxpayer then
executes an old-fashioned exchange by trading his individually owned,
low-basis property for the high-basis property his corporation owns.
The basis remains with the owner — it doesn't transfer with the
property — so the corporation now owns a high-basis property that will
result in minor tax consequences when sold. In this scenario, the
taxpayer shifted basis immediately before the sale and simply cashed
out; therefore, an exchange wasn't necessary due to the minor tax
Tightening the Rules
1989, the IRS recognized this loophole and added an anti-abuse
provision: Section 1031(f) — Special Rules for Exchanges Between
Related Persons. In Section 1031(f)(1), the IRS restricted
related-party exchanges by mandating that the property acquired by the
related party could not be sold for a minimum of two years. There were
several exceptions to the rule, including the taxpayer's or the related
party's death and cases of compulsory or involuntary conversions, such
as seizure by eminent domain or the property's destruction.
the primary objective of Section 1031(f) was to end abusive basis
shifting. Since the IRS's requirements seemed clear, no distinction was
made between selling a relinquished property to or buying a replacement
property from a related party.
Eight years after enacting
Section 1031(f), the IRS surprised many tax professionals with Tax
Advisory Memorandum 9748006, which stipulated that replacement property
could not be purchased from a related party. The memorandum stated that
tax avoidance was the primary motivation for buying replacement
property in such situations.
The following illustrates the IRS'
reasons for issuing TAM 9748006. A mother and son jointly owned
property that they decided to sell. The mother did not structure her
part of the sale as an exchange and intended to use her portion of the
proceeds to buy a primary residence. The son structured his part of the
sale as a tax-deferred exchange and identified three potential
replacement properties, one of which was the home that his mother had
just purchased. The son unsuccessfully tried to negotiate contracts on
the first two replacement properties and ultimately bought his mother's
In this situation, the IRS found the exchange to be
invalid and the son's gain was triggered because he purchased the
replacement property from a related party. The taxpayer argued that he
had not tried to circumvent the rules since he did not have a
prearranged plan to buy his mother's house. However, the IRS stated
that a prearranged plan between related parties was not necessary for
there to be a violation of Section 1031(f)(4), which invalidates any
exchange that is part of a transaction structured to avoid the purposes
of the related-party rule.
Analysis of New Ruling
Rev. Ruling 2002-83, the IRS further clarifies the rules governing
related-party transactions. The ruling clearly states that an
acquisition of replacement property from a related party violates both
Section 1031(f)(1) and 1031(f)(4).
The author of Rev. Ruling
2002-83 used a taxpayer's sale of a low-basis property and acquisition
of a high-basis property from a related party as an example of a
violation under 1031(f), thereby illustrating the IRS' intent to place
substantial restrictions on related-party transactions.
whether an abuse has taken place, the IRS interprets transactions
without the use of a qualified intermediary. First, a diagram of the
exchange is crafted to illustrate the taxpayer and the related party
executing a direct trade or “swap” of their properties. Next, the
transaction is examined as if the related party sold the property it
just received to an independent third party for cash. In this instance,
the IRS would infer abuse of the rule because the related party did not
hold the property for two years, thereby violating the Section
1031(f)(1) rules. Using this methodology, almost any transaction
involving an acquisition from a related party would not qualify.
this ruling permanently eliminate the purchase of property from a
related party? Probably. Does the related party's basis matter in the
analysis? Possibly. It appears that the IRS practically has eliminated
the option of buying replacement property from a related party;
essentially, taxpayers only can sell property to related parties in
exchanges as long as they abide by the two-year holding period.
addition, planned basis shifting is not dead. A taxpayer recently
received a favorable opinion from the IRS in Field Service Advisory
200137003 wherein the taxpayer planned to do a related-party basis
shift, exchanging low-basis property for high-basis property, and then
selling the high-basis property. This is a classic example of the basis
shifting scheme with one exception — the sale of the high-basis
property did not occur for two years.
In summary, taxpayers
should be careful: Not all related-party transactions are alike.
Consult a tax professional before executing a related-party exchange.