Related Party Rules in a § 1031 Exchange

Over the years there may have been sit­u­a­tions where an investor has pushed the lim­its attempt­ing to exe­cute a §1031 tax deferred exchange. When­ev­er there are tax ben­e­fits to be gained some­one may strate­gize on how to take advan­tage of the sys­tem.  

By Al DiNi­co­la, AIF®, CEPA™
Octo­ber 10, 2023
Adinicola@namcoa.com
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD

The IRS has sure­ly reviewed enough exchange cas­es that have result­ed in rejec­tion or valid­i­ty of the investor’s exchange. An over­looked pro­vi­sion of the exchange is ref­er­enced as a “relat­ed par­ty”.

The IRS con­stant­ly issues rul­ing on many facets of the code and specif­i­cal­ly to the §1031 tax deferred exchange process. Cer­tain tax­pay­ers may be seek­ing to avoid pay­ing any tax­es let alone defer­ring tax­es. Investors engage in a §1031 to max­i­mize the growth of their wealth and as a pow­er­ful strat­e­gy for defer­ring cap­i­tal gains tax.

How­ev­er, the com­plex­i­ty of the Inter­nal Rev­enue Code can pose chal­lenges, espe­cial­ly when relat­ed-par­ty trans­ac­tions are involved. We may be able to assist if you are think­ing about enter­ing into an exchange. We do not pro­vide tax advice. How­ev­er, we have been involved in count­less exchanges and under­stand the pro­ce­dure and pru­dent steps to be tak­en.

Under­stand­ing the intri­ca­cies of exchang­ing with a relat­ed par­ty is cru­cial. Over the years we have writ­ten many arti­cles on §1031 as well as uti­liz­ing a Delaware Statu­to­ry Trust (DST) as a qual­i­fy­ing replace­ment prop­er­ty for a §1031.  The intent of this arti­cle is to be edu­ca­tion­al in nature for investors attempt­ing to uti­lize a tra­di­tion­al §1031 exchange. By struc­ture and func­tion DST are not a relat­ed par­ty to an investor. Investors may not be aware of the relat­ed par­ty rules and look to make the exchange easy.

The DST Solu­tion- no relat­ed par­ty and maybe an easy solu­tion.

Once DST gained approval as an accept­ed replace­ment for §1031 exchanges (about 20 years ago) they have been wide­ly used to sat­is­fy all aspects of the 1031. Specif­i­cal­ly, the equal to or exceed the relin­quished prop­er­ty val­ue, required debt replace­ment if need­ed (with non-recourse debt), and adher­ing to all tim­ing require­ments because DSTs are sit­ting on the shelf. This pre-pack­aged aspect of DSTs makes it real­ly easy for the investor to sat­is­fy all require­ments.

The Two-Year Hold­ing Require­ment

When it comes to relat­ed-par­ty trans­ac­tions, Sec­tion 1031(f) adds an addi­tion­al lay­er of com­plex­i­ty. If a tax­pay­er choos­es to engage in a §1031 exchange with a relat­ed par­ty, both par­ties are required to hold onto the acquired prop­er­ties for a min­i­mum of two years. Fail­ure to adhere to this hold­ing peri­od results in the dis­al­lowance of the exchange, trig­ger­ing cap­i­tal gains tax.

Defin­ing Relat­ed Par­ties

Relat­ed par­ties include lin­ear blood rel­a­tives and enti­ties in which the tax­pay­er owns an inter­est. How­ev­er, this def­i­n­i­tion extends to cer­tain trusts and enti­ties, mak­ing it imper­a­tive to ful­ly under­stand the scope of these rela­tion­ships. There are about 16 dif­fer­ent relat­ed par­ty sit­u­a­tions called out by the IRC. When you may least expect a relat­ed par­ty sit­u­a­tion to exist, it just may exist. This is espe­cial­ly true in cor­po­ra­tions, trusts, and fam­i­lies. Con­tact us for an expand­ed list of poten­tial relat­ed par­ty sit­u­a­tions.

Avoid­ing the Two-Year Rule: A Cau­tion­ary Tale

Sec­tion 1031(f)(4) was estab­lished to pre­vent tax­pay­ers from cir­cum­vent­ing the two-year hold­ing require­ment through strate­gic struc­tur­ing of exchanges. For exam­ple, a tax­pay­er can­not avoid the two-year rule by sell­ing the replace­ment prop­er­ty to the buy­er of the relin­quished prop­er­ty who then exchanges it back to the tax­pay­er. Despite this, some have attempt­ed to nav­i­gate around the rule, lead­ing to legal scruti­ny. The rea­son for the change was to dis­cour­age “basis shift­ing” where a tax­pay­er with a low basis trades prop­er­ties with a relat­ed tax­pay­er with a high basis prop­er­ty. This is done to elim­i­nate or reduce cap­i­tal gains tax­es on the sale of the prop­er­ty that orig­i­nal­ly had a low basis (and now in the hands of the relat­ed par­ty, has a high basis).

Courts have ruled in sev­er­al cas­es that using an accom­moda­tor to hold funds in an exchange is equiv­a­lent to attempt­ing to avoid the two-year rule. This results in the dis­al­lowance of the exchange, even if the tax­pay­er was to hold the replace­ment prop­er­ty for the required two years.

What Should You Do?

Engag­ing in a 1031 exchange with a relat­ed par­ty demands care­ful con­sid­er­a­tion and a thor­ough under­stand­ing of the Inter­nal Rev­enue Code. The two-year hold­ing require­ment and the intri­ca­cies of relat­ed-par­ty def­i­n­i­tions make these trans­ac­tions espe­cial­ly com­plex. Ini­tial­ly, relat­ed par­ties could do a 1031 exchange with­out any addi­tion­al con­di­tions. In 1989, the IRS rec­og­nized this loop­hole and added an anti-abuse pro­vi­sion: IRC Sec­tion 1031(f) — Spe­cial Rules for Exchanges Between Relat­ed Per­sons.

Final Words

Tax­pay­ers who may be fol­low­ing the path of least resis­tance and are swap­ping with or sell­ing to some­one they know (relat­ed par­ty) should be able to struc­ture a valid exchange. The val­i­da­tion or proof of intent will be as long as both the tax­pay­er and the relat­ed par­ty hold the prop­er­ties acquired in the exchange for a peri­od of at least two years after the last trans­fer in the exchange. Tax­pay­ers (with or with­out knowl­edge of the rules) who are buy­ing from a relat­ed par­ty will gen­er­al­ly find that their exchanges are dis­qual­i­fied, espe­cial­ly if only held for a short peri­od of time. As always con­sult your tax con­sul­tant and pre­pare for your exchange.

NAMCOA® is a SEC reg­is­tered invest­ment advi­so­ry firm that pro­vides com­pre­hen­sive port­fo­lio man­age­ment, finan­cial plan­ning, and fidu­cia­ry deci­sion-mak­ing ser­vices on behalf of retire­ment plan spon­sors. Our Dif­fer­ence is sum­ma­rized by our fidu­cia­ry approach which enables us to bet­ter meet port­fo­lio and retire­ment plan objec­tives, result­ing in stronger risk adjust­ed returns for investors and peace of mind for Clients. We also focus on alter­na­tive real estate invest­ment. Many real estate investors are seek­ing tax deferred solu­tions uti­liz­ing §1031 exchanges or Oppor­tu­ni­ty Zones.

DSTs are not for all investors.  The acqui­si­tion of a DST is for accred­it­ed investors only.  Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin- Sher­wood Rd, Suite 200, Tualatin, OR 97062.  MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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