Related-Party Like-Kind Property Exchanges: Recent IRS Guidance

By Nancy B. Nichols, Jill Mayclim, and M. Cathy Sullivan

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Like-Kind Exchanges

Generally no gain or loss is recognized on the exchange of like-kind property. Like-kind property is defined as property held for productive use in a trade or business or for investment that is exchanged solely for similar property. The basis of the property acquired is the same as the basis of the property exchanged, decreased by any boot (property other than like-kind) received and increased (or decreased) by the gain (or loss) recognized by the taxpayer. (See “Like-Kind Real Estate Exchanges Under IRC Section 1031,” The CPA Journal, November 2001.)

Related-party restrictions. As part of the Omnibus Budget Reconciliation Act of 1989, Congress enacted additional requirements for like-kind exchanges between related parties [IRC section 1031(f)]. The additional rules are intended to eliminate the benefits that related parties were receiving by exchanging low-basis property for high-basis property in anticipation of the profitable sale of the low-basis property.

To avoid this “shifting of basis,” IRC section 1031(f) requires a two-year holding period after an exchange between related parties. If either the taxpayer or the related party disposes of the exchanged property within two years, then the taxpayer’s exchange with the related party becomes taxable.

Related party defined. For purposes of the like-kind exchange rules, the definition of related parties is a combination of related parties as defined under IRC section 267(b) and section 707(b). Combining these two sections, related parties include the following:

• Family members (siblings, spouses, ancestors, and lineal descendants);
• An individual and an entity (corporation or partnership) where the individual owns either directly or indirectly more than 50% in value of the entity;
• Two entities in which the same individual owns directly or indirectly more than 50% of each;
• An estate in which the taxpayer is either the executor or beneficiary of the estate; and
• A trust in which the taxpayer is the fiduciary and the related party is a beneficiary either of that same trust or a related trust or a fiduciary of a related trust.

Two-year holding period. IRC section 1031(f) created a two-year holding period for property given up or received in a like-kind exchange between related parties. The nonrecognition treatment under section 1031 is lost if either property in the exchange is disposed of within two years. Thus, if either the taxpayer or the related party disposes of the property received in the exchange within two years, the gain or loss is triggered for both parties. Section 1031(f) does not bar related-party exchanges, it merely requires a longer holding period to deter taxpayers from shifting low-basis property with high-basis property in anticipation of selling the low-basis property, thus substantially reducing the amount of gain recognized on the transaction.

Related parties often overlook the “suspension” provisions in IRC section 1031(g) that can extend the two-year holding period. The two-year holding period is suspended if either the taxpayer’s or the related party’s risk of loss is substantially decreased (due to an option, put, or other transaction). Once the risk of loss ceases, the two-year period continues from the point where it stopped.

For example, Taxpayer exchanges property with Related Party. Twelve months later, Third Party acquires an option to acquire the property from Related Party. The option expires 12 months later and Related Party waits seven months and sells the property. Even though the sale is 31 months after the original exchange, Taxpayer’s gain from the original exchange is triggered, because the two-year holding period was suspended during the time the option was outstanding, so the sale is deemed to occur only 19 months after the exchange.

Additional exceptions exist to the two-year holding period. Under IRC section 1031(f)(2), if the taxpayer or related party dies and the property is disposed of within the two-year holding period, gain will not be triggered to the second party. In addition, the two-year limitation will not apply if the property is disposed of due to an involuntary conversion and the original exchange occurred before the threat or imminence of such conversion. The third exception provides that if the taxpayer can establish that neither the original exchange nor the subsequent disposition within the two-year period was undertaken for the purpose of avoiding tax, then the original exchange will not fail.

The IRS has provided guidance regarding the third exception in two letter rulings. In PLR 9116009, the IRS held that a taxpayer’s transfer of property acquired in a like-kind exchange with a related party to a grantor trust within two years of the exchange is not a disposition under section 1031(f). The second letter ruling, PLR 199926045, involves the cutting of timber on the replacement property received in a like-kind exchange from a related party. Here, the IRS ruled that the taxpayer’s original exchange remained intact and that the subsequent cutting of timber by a related party within the two-year period did not trigger a gain to the taxpayer.

Anti-abuse Provision

IRC section 1031(f)(4) provides that deferred treatment is denied in any exchange that “is part of a transaction (or series of transactions) structured to avoid” the purpose of the related-party rules. This catchall provision causes many exchanges to fail and is often misunderstood or overlooked.

Recent IRS guidance. Application of the anti-abuse provision with the use of a qualified intermediary in a related-party like-kind exchange has resulted in a number of IRS rulings, most recently Revenue Ruling 2002-83 (2002-49 IRS 927, 11/25/2002). This ruling prevents related parties from deferring recognition of gain by using a qualified intermediary when the related party receives cash or non–like-kind property.

For example, Bob owns Property 1 worth $100 with a basis of $10, and his brother Jim owns Property 2 worth $100 with a basis of $100. Jane, an unrelated party, wants to acquire Property 1 for $100. To complete the transfer, Bob enters into an agreement to exchange Property 1 and 2 with Jim, Jane, and a qualified intermediary (QI) unrelated and independent of Bob and Jim. Bob transfers his low-basis Property 1 to QI; QI then exchanges Property 1 with Jane for cash; QI attains high-basis Property 2 from Jim for cash, and transfers Property 2 to Bob. Bob has engaged in a like-kind exchange with QI (an unrelated third party) instead of with Jim. Essentially, the result of the transaction, if one removes the QI, is as follows: Bob and Jim have exchanged properties, and Jim sold the property received in the exchange to Jane for cash. According to the ruling, a related party is not entitled to nonrecognition treatment under section 1031 if the related party receives cash or other non–like-kind property for the property received in a transaction that uses a QI to exchange the property. In this example, Jim has received non–like-kind property (cash); thus, the provisions of 1031 will not apply, and Bob must recognize his gain of $90.

In making the ruling, the IRS relied on the anti-abuse provision of IRC section 1031(f)(4), holding that the QI was used to circumvent the purpose of the related-party rules and, therefore, the nonrecognition provisions of section 1031 do not apply. In Technical Advice Memorandum (TAM) 9748006 (11/28/1997), the IRS used the same approach for analyzing a like-kind exchange involving related parties, a QI, and an unrelated third party. In general, the IRS looks to the final outcome to determine whether a related party “cashed out.” If a related party has cashed out, then the transaction will not qualify for nonrecognition treatment under section 1031.

TAM 2001-26007 involves a complicated set of transactions between two corporations meeting the related-party definition due to common stock ownership by members of two families. The transactions involved a QI and two unrelated parties. Ultimately, the transactions shifted the taxpayer’s low basis in its property to the replacement property previously owned by the related party. The related party eventually received cash that it used to reduce bank debt. In the end, the related party “cashed out” of its investments, denying the taxpayer nonrecongition treatment on the transactions.

Field Service Advice (FSA) Memorandum 2001-37003 provides that if related parties exchange properties, nonrecognition treatment of the gain is permitted as long as the subsequent disposition of the replacement property occurs after two years of the initial exchange. The IRS concluded “the two-year rule in section 1031(f)(1)(C) is a safe harbor that precludes application of section 1031(f)(1) to any transaction falling outside that period.” Therefore, related parties can avoid the anti-abuse rules just by waiting two years. The FSA states that the purpose of the anti-abuse provisions is to “stop taxpayers from violating the two-year rule, and not to preclude taxpayers from planning to dispose of property after the two-year period.” Taxpayers can enter into a related-party exchange with the intent of selling the property after two years without triggering recognition of the original gain as long as the transaction was not a sham.

Planning Considerations

The restrictions and potential pitfalls of related-party like-kind exchanges would seem to limit the tax benefits of these transactions. The opportunity for tax deferral, available for all like-kind exchanges, still applies to related-party transactions. In many situations, tax deferral coupled with estate planning objectives make related-party like-kind exchanges very attractive.

From an estate planning perspective, like-kind exchanges may result in taxes never being paid on the investment. If a taxpayer who has participated in a section 1031 exchange dies, the property is left to heirs without being subject to capital gains tax. Properties are revalued when the taxpayer dies, and the accumulated capital gains that were never recognized are wiped clean.

Other estate planning objectives can also be accomplished through like-kind exchanges. For example, retiring parents with a family farm may exchange the farm for smaller real estate parcels that are investments owned by their children. These smaller parcels can then be gifted back to the children over time. Or the parents may retain ownership of the properties and sell them over a period of years, after the two-year holding period has been met. This plan would give the retired couple additional funds in retirement by allowing them to control when and how much gain they realize.

If the children do not have investment properties that meet the parents’ needs, a multiparty exchange may be the answer. As long as the parents and children do not cash out for two years, the nonrecognition provisions under section 1031 will still apply.

The shifting of basis still works for related parties, but requires a little more work. For example, a taxpayer who owns a property with low basis that has appreciated significantly can still consider exchanging the property with a related party that owns investment property with a higher basis. As made clear in FSA 2001-37003, the related parties can avoid the anti-abuse provision by waiting two years to sell the property. This technique works especially well in the following situation: A parent owns investment land that is appreciating significantly. The area where the land is located is beginning to develop and the parent knows that the property will eventually be sold. A child has rental property that generates income but is not appreciating as rapidly. The child does not need the rental income and the parent could use the income to supplement his retirement. A like-kind exchange is ideal. Not only will the tax on the ultimate sale be lower because of the child’s higher basis, but also the additional appreciation during the two-year holding period will have been transferred to the child.

Reporting requirements. IRS Form 8824, Like-Kind Exchanges, must be filed when an exchange involving like-kind property occurs. When related parties exchange property, additional information is required, including the name, address, identifying number, and relationship of the related party. In addition, Form 8824 must be filed for the year of exchange and also for the two years following the exchange to provide the IRS with the information necessary to monitor the two-year holding requirement.