“Like Kind Exchanges Between Related Parties” by William E. Evans
In general, Section 1031 of the Internal Revenue Code (the “Code”) allows the deferral of gain recognition on the disposition of real and personal property if the taxpayer replaces the disposed property with property of “like
kind.” The provisions of Section 1031 can be complicated and confusing, but this deferral of gain feature is often used, especially with respect to real estate, mainly because the definition of “like kind” real estate is very
broad; i.e., improved property is like kind to unimproved property.
In 1989, Subsection (f) was added providing special rules relating to exchanges between “related parties.” “Related parties” include family members and entities where the taxpayer owns fifty percent or more of the entity. Generally, if related parties exchange property between themselves, each party must hold the property received
in the exchange for a period of two years before disposing of it in a taxable transaction. This Subsection (f) was designed to prevent “basis shifting” among related taxpayers. In a Section 1031 exchange, a taxpayer receives a carryover basis in the replacement property equal to what he had in the relinquished property. For example, if a taxpayer wants to sell his low basis property, absent Section 1031(f), the taxpayer could exchange his low basis property for his spouse’s high basis property. The spouse could then sell taxpayer’s property for little or no gain
because of the carryover basis received by the spouse on the spouse’s replacement property received in the exchange. Section 1031(f) prohibits this by requiring both taxpayer and spouse to hold the properties for two years.
A more likely scenario that is common today involves a taxpayer with two or more related entities owning real estate. As it is unlikely that two taxpayers will have property that the other wants, exchanges usually involve intermediaries who, under the deferred exchanges rules of Section 1031, coordinate the exchange with a third party
buyer. In seeking replacement property, a taxpayer will often designate property owned by a related party. The common misconception made here is that the acquisition of replacement property from a related party will qualify for Section 1031 treatment so long as the taxpayer holds the replacement property for two years. Nothing could be further from the truth. The IRS has taken the position that you cannot acquire replacement property from a related taxpayer in a Section 1031 exchange. This position has been recently adopted by the Tax Court this year in Teruya Brothers, Ltd. v. Commissioner. The IRS and the Tax Court now take the position that, generally speaking, you cannot acquire replacement property from a related taxpayer and still qualify for tax deferral under Section 1031 because one of the related parties is “cashing out” in the exchange. There are some exceptions to this general rule that we believe apply under certain circumstances. If you are contemplating a Section 1031 exchange involving a related taxpayer, you should use extreme caution and consult with your tax professional to make sure the exchange qualifies for tax deferral under the Code