With the many tax advantages which come with the 1031 exchange however, there has been significant fraud over the years from investors who have utilized different “related parties” strategies or methods to delay, avoid or even dodge the payment of taxes on income.
Over the past 10 years 1031 Exchanges have definitely not been exempt from such tax evasion The Internal Revenue Service (“IRS”) has issued guidelines and rules on related parties to 1031 Exchange transactions to prevent the abuse of investors.
Are you thinking about making a 1031 exchange into the Delaware Statutory Trust? Contact us now via Tax & Law Research Inc. for the proper advice.
Who Is Considered As A Related Party In An Exchange Of 1031?
“Related person” or “related to” (or “related party” refers to any person or entity, including entities, who has an affiliation with the taxpayer as defined by the Section 267(b) (b) or 707(b)(1) of the Internal Revenue Code (IRC) which includes:
Family members of the same lineage (siblings spouse, ancestors, spouses and lineal descendants)
Corporation in which more than 50% of the worth of the stock is held directly or indirectly for one person.
Corporations which are part of the same group of controlled entities (as as defined by subsection (f))
A fiduciary and a grantor of any trust
A fiduciary for one trust as well as the fiduciary or beneficiary another trust, where that same individual is also the trustee of both trusts.
A fiduciary in a trust as well as a beneficiary that trust
Corporation in which more than 50% of the of its stock held through or on behalf of a particular trust, or by or on behalf of the fiduciary or grantor of the trust.
A company that is eligible as a nonprofit organization Section 501 of the Internal Revenue Code (relating to specific charitable or educational non-profit organizations) that is managed directly or indirectly specific individual or, if the particular person belongs to an individual is controlled by the family of the individual.
A partnership and a corporation when the same person or individuals have:
More than 50 percent value of the outstanding shares of the company,
More than 50% of capital interests or the profit interest, in the partnership
An S corporation as well as another S corporation or C corporation, if the same person or individuals are owners of more than 50% in the value of the outstanding shares of each corporation.
A partnership, as well as an individual who owns directly or indirectly more than 50 percent capital interest, or a 50-percent profits interest, in a partnership
Two partnerships where the same individual or persons hold, either directly or indirectly more than a 50% capital interest, or a 50-percent profit interest in both partnerships.
Executors Of Estates As Well As The Beneficiaries.
A testamentary trust set up by a spouse and an inter living generation skipping trust that was created by a wife aren’t closely related since they did not share the same grantor, as per Public Letter Ruling 92224008. Investors might be able to solve related party transaction issues with the change in ownership to the related party like the transfer or disposal of the partnership’s interests or shares of a corporation to a non-related third-party to bring the ownership stake of the related party lower than 50 percent.
The The IRS 1031 Exchange Related Party Rules
At first, parties with a common interest could exchange their 1031s without additional requirements. In 1989 the IRS acknowledged this loophole and added a provision to prevent abuse: IRC Section 1031(f) – Specific Rules for Exchanges between Related People.
The motivation behind this change was to stop “basis shifting” in which a tax payer with an extremely low basis sells their property in conjunction with a taxpayer related to them who owns the same basis. This can be done to avoid or minimize capital gains tax for the sale of the property with low basis (and is now in the possession of the associated party, has a higher basis).
The section 1031 (f) or 1031 exchange related rules dealt with four main aspects swapping with a related party trading with a similar party purchasing from a related party and various exemptions from the regulations.
Swapping In Conjunction With A Third
If you swap with a similar party, in the sense that you surrender property to that party , and receiving replacement property from the associated party, you are able to make an exchange if the parties involved and you are the owners of the property purchased in exchange for at least two years from the date of the previous transfer which was an exchange.
In the event that you, or the associated person sells the property prior to this date, both transactions are not eligible. Both parties will be required to be taxed on the gains. This tax will be due during the tax year which the selling of the property purchased during the exchange.
Selling To An Associated Third
There have been times when individuals have attempted to circumvent the restrictions of related party exchanges through arranging an exchange through an intermediary. The idea is that an intermediary exchanged with the taxpayer, and thus it wasn’t an exchange between related parties. There have been numerous decisions and cases, however they have concluded that the use of an intermediary does not eliminate the restrictions on related parties because of Internal Revenue Code Section 1031(f)(4) which states that the advantages of Section 1031 do not apply “to any exchange that is part of the course of a transaction (or sequence of transactions) designed to defy the requirements in this section.”
It is possible to make an exchange with an intermediary in the event that you sell to a related person and purchasing from an unrelated person. The standard recommendation, based upon Section 1031(f) and Section 1031(f) is that you and the other party must keep the property you purchased for at least two years following an exchange.
A Purchase Made From A Connected Third
It is important to note that the IRS is adamant that there isn’t any tax avoidance or basis shifting in the event that a taxpayer, via the unrelated Qualified Intermediary, transfers Relinquished Property to an associated buyer, but buys Replacement Property from an unrelated seller. The exchange will likely be recognized regardless of whether the buyer chooses to sell the property that it purchased through the taxpayer in the two-year period from the date of the acquisition.
The reason behind the concept is that the only taxpayer was the owner of property prior to the exchange, and that the taxpayer remained investing in similar properties following the exchange. Since the buyer of the exchange didn’t own property at the time of the swap, any later disposal would not lead to the cashing out or basis shifting of the taxpayer.
Do You Know Of Any Other Rules That Aren’t Covered By Related Party Rules?
As mentioned above, the two-year hold period exemption is only applicable only to transactions between taxpayers who acquire (and hold) the other’s property. In this case, if the property is held for a minimum period of two years, there’s an expectation that the transaction was motivated by an objective different from “abusive shift of basis.”
Another exception, in Section SS1031(f)(2)(C) permits an earlier than two years disposal of property which forms part of a related-party transaction. The law states that the transaction is not exempt if “with regard to which it is proven to satisfaction by the [TreasurySecretary it is not proven that the transaction or the disposal had as one of its primary objectives the deferral of Federal tax on income.” Many exchanges are based on tax deferral. Therefore, it’s difficult to prove this claim. However, there have been some favorable IRS rulings where families exchanged their undivided interest in several properties to let each of them be a part of a. This is an excellent illustration of this type of exception.
A different exception stems from an assortment of private letters revenue rulings, beginning at the PLR of 201220012 that dealt with the sale of a replacement property within the period of two years. The decision concluded that, since the person who was related to him made an exchange of the property to another property, there was no cashing out, and thus no tax fraud.
A third and less frequently used alternative to the obligation for each party retaining the property for two or more years can be triggered in the event of dying of the tax payer or spouse or a person who is related to them. In this case, it is possible for the exchanged property to be transferred within the period of two years but preserving the original deferral.
Requirements For Reporting
IRS Form 8824, also known as Like-Kind Exchanges must be completed in the event that a 1031 exchange involving similar-kind property takes place. If related parties exchange property it is necessary to provide additional information in addition to the address, name as well as the taxpayer identification number also known as social security numbers and the relationship of the exchanged party.
Summary
Taxpayers swapping against or selling their property to an associated party must be able to create an exchange that is valid as long that both you and your associated party own the property purchased in exchange for minimum two years following the last transfer made during the exchange. Taxpayers who purchase from a related entity typically be able to determine that their exchanges aren’t eligible. There are a few possible exceptions, and it is essential to discuss the transaction with your tax advisor.
Do you need assistance in making a 1031 exchange into the Delaware Statutory Trust? Contact us now by calling Tax & Law Research Inc. to get the right advice.
