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1031 Exchange Related Party Issues

"Related party" strategies have been the subject of a great deal of abuse in party 1031 Exchange transactions over the years, as Investors typically take advantage of said strategies in order to neglect paying of their income tax liabilities. This is something that the Internal Revenue Service obviously frowns upon, and to counteract such abuses, they have instituted an exhaustive list of rules that Investors are expected to follow, lest they face stiff Federal penalties.

There is a special rule for exchanges between related parties which requires related taxpayers exchanging property with each other to hold the exchanged property for at least two years following the exchange to qualify for non-recognition treatment. If either party disposes of the property received in the exchange before the running of the two-year period, any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs.

Sale to an unrelated party, replacement from a related party. A taxpayer will often desire to sell to an unrelated party and receive replacement property from a related party. This type of related party transaction does not work, according to the IRS, if the related party receives cash. The IRS reasons that if the taxpayer or a related party "cashes out" of property in this manner, the exchange is disallowed. However, if the related party is also doing an exchange (and is not "cashing out") then it is okay to receive replacement property from a related party.

Sale to a related party, replacement from an unrelated party. A taxpayer will often sell to a related party but receive replacement property from an unrelated party. This is OK but it has been unclear whether the related party was required to hold the property it acquired from the taxpayer for two years. Tax and exchange professionals have generally advised their clients to comply with the two-year rule. However, the two-year rule does not apply to a related party who purchased the relinquished property from the taxpayer.

Related parties under the rules are the following:

  • Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.);
  • An individual and a corporation when the individual owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;
  • Two corporations that are members of the same controlled group as defined in §1563(a), except that "more than 50%" is substituted for "at least 80%" in that definition;
  • A trust fiduciary and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;
  • A grantor and fiduciary, and the fiduciary and beneficiary, of any trust;
  • Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts;
  • A tax-exempt educational or charitable organization and a person who, directly or indirectly, controls such an organization, or a member of that person's family;
  • A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest, or profits interest, in the partnership;
  • Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation;
  • Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation; or
  • An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.
  • Two partnerships if the same persons own directly, or indirectly, more than 50% of the capital interests or profits in both partnerships, or
  • A person and a partnership when the person owns, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership.

A disqualifying disposition does not include dispositions by reason of the death of either party, the compulsory or involuntary conversion of the exchanged property if the exchange occurred before the threat or imminence of the conversion, or dispositions where it is established to the satisfaction of the IRS that neither the exchange nor the disposition had as one of their principal purposes the avoidance of federal income tax.

Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.

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