Section 1031 & Development of Related Parties

Over the past few years investors have asked ques­tions about sell­ing their invest­ment prop­er­ty to fam­i­ly mem­bers. There may be many rea­sons why investors may wish to keep the prop­er­ty “in the fam­i­ly”. 

Novem­ber 6, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

How­ev­er, there are spe­cif­ic rules address­ing this trans­fer of title espe­cial­ly when the investor is attempt­ing to exe­cute a 1031 exchange.

Since its incep­tion in 1921, IRC Sec­tion 1031 has been a piv­otal com­po­nent of the Tax Code, designed to pro­mote the con­ti­nu­ity of invest­ments by allow­ing for tax defer­rals. This mech­a­nism facil­i­tates an investor, an “Exchang­or” or “Tax­pay­er,” to trans­fer a relin­quished prop­er­ty and acquire a replace­ment prop­er­ty with­out imme­di­ate tax impli­ca­tions. This arti­cle delves into the his­tor­i­cal con­text, the intro­duc­tion of relat­ed par­ty rules, excep­tions to these rules, and the attri­bu­tion rules involved.

His­tor­i­cal Con­text of 1031 Exchanges

Ini­tial­ly, the essence of Sec­tion 1031 was straight­for­ward: an Exchang­or could sell the appre­ci­at­ed prop­er­ty and rein­vest the pro­ceeds into anoth­er prop­er­ty, thus defer­ring any cap­i­tal gains tax. The pri­ma­ry objec­tive was to encour­age con­tin­u­ous invest­ment in real estate with­out inter­rupt­ing tax lia­bil­i­ties, pro­vid­ed there was no cash out dur­ing the trans­ac­tion.

The Rise of Abu­sive Prac­tices

Over time, how­ev­er, some Exchang­ors and their advi­sors began exploit­ing this favor­able tax treat­ment. They manip­u­lat­ed the sys­tem by using relat­ed par­ties, such as cor­po­rate sub­sidiaries. For exam­ple, Com­pa­ny A could exchange its high-val­ue, low-basis prop­er­ty with its sub­sidiary, Com­pa­ny AB, for a high-basis, high-val­ue prop­er­ty. Com­pa­ny A would then ben­e­fit from tax defer­ral, while Com­pa­ny AB could sell the new­ly acquired prop­er­ty with min­i­mal tax due to its high basis. This prac­tice, known as “abu­sive basis shift­ing,” allowed groups of com­pa­nies to divest from high-gain prop­er­ties with­out incur­ring sig­nif­i­cant tax lia­bil­i­ties.

Intro­duc­tion of Relat­ed Par­ty Rules

In 1989 Con­gress intro­duced the Relat­ed Par­ty Rules with­in Sec­tion 1031 to curb these abus­es. Specif­i­cal­ly, Sec­tion 1031(f)(1) dis­al­lows an exchange if either relat­ed par­ty sells the received prop­er­ty with­in two years of the exchange. This pro­vi­sion ensures that both par­ties rec­og­nize any deferred gain or loss if a sub­se­quent dis­po­si­tion occurs with­in this peri­od. The sub­stan­tial hold­ing peri­od is intend­ed to deter trans­ac­tions struc­tured pri­mar­i­ly for tax avoid­ance. Fur­ther­more, Sec­tion 1031(f)(4) impos­es an anti-abuse rule, stip­u­lat­ing that any exchange to cir­cum­vent this subsection’s pur­pose is invalid.

Per­mis­si­ble Relat­ed Par­ty Trans­ac­tions

Inter­est­ing­ly, sell­ing relin­quished prop­er­ty to a relat­ed par­ty is not pro­hib­it­ed, as it does not lead to the same tax abuse poten­tial as pur­chas­ing from a relat­ed par­ty. How­ev­er, sev­er­al excep­tions allow for relat­ed par­ty exchanges:

1.         Prov­ing No Tax Avoid­ance Intent: The Exchang­or must demon­strate to the IRS that the prin­ci­pal pur­pose of the exchange was not tax avoid­ance. This excep­tion is chal­leng­ing to sat­is­fy, as tax defer­ral is inher­ent­ly a pri­ma­ry objec­tive of exchanges. Nonethe­less, it has been suc­cess­ful­ly applied in sce­nar­ios where fam­i­ly mem­bers con­sol­i­date prop­er­ty inter­ests.

2.         Sub­se­quent Exchange by Relat­ed Par­ty: If the relat­ed par­ty con­duct­ing the exchange also engages in a sub­se­quent exchange, this indi­cates a legit­i­mate busi­ness pur­pose beyond mere tax avoid­ance.

3.         Sec­tion 1031(f)(2)© Excep­tions: This sec­tion allows exchanges with relat­ed per­sons if not pri­mar­i­ly for tax avoid­ance. The Sen­ate Finance Com­mit­tee out­lined three qual­i­fy­ing exam­ples:

• Exchang­ing frac­tion­al inter­ests result­ing in each tax­pay­er own­ing a whole or larg­er share of the prop­er­ty.
• Prop­er­ty dis­po­si­tion in a non-recog­ni­tion trans­ac­tion, such as con­tribut­ing to a part­ner­ship or cor­po­ra­tion.
• Exchanges that do not alter the basis of the involved prop­er­ties.

Def­i­n­i­tion and Iden­ti­fi­ca­tion of Relat­ed Par­ties

Sec­tion 1031(f) address­es exchanges between relat­ed par­ties, defined by I.R.C. § 267(b) and § 707(b)(1). Relat­ed par­ties include fam­i­ly mem­bers (spous­es, par­ents, sib­lings) and enti­ties with sig­nif­i­cant com­mon own­er­ship. For instance, par­ent cor­po­ra­tions and their sub­sidiaries or part­ner­ships where one per­son owns more than 50% inter­est are con­sid­ered relat­ed. The exten­sive attri­bu­tion rules under Sec­tions 267 and 707 ensure com­pre­hen­sive cov­er­age of poten­tial relat­ed par­ties.

Attri­bu­tion Rules for Relat­ed Par­ties

The attri­bu­tion rules under Sec­tions 267(b) and 707(b) are com­pre­hen­sive, includ­ing fam­i­ly mem­bers, relat­ed trusts, part­ner­ships, and cor­po­ra­tions as “dis­qual­i­fied per­sons.” These rules require detailed trac­ing of own­er­ship and famil­ial con­nec­tions. The con­struc­tive own­er­ship rules in Sec­tion 267© fur­ther elab­o­rate on these rela­tion­ships, deem­ing own­er­ship through indi­rect means such as trusts or part­ner­ships.

Con­struc­tive Receipt Rules

When apply­ing these rules, an indi­vid­ual is con­sid­ered to own inter­ests held by fam­i­ly mem­bers or relat­ed enti­ties. This some­times neces­si­tates ref­er­enc­ing Sec­tion 267© to deter­mine spe­cif­ic rela­tion­ships. For exam­ple, fam­i­ly mem­bers are defined to include sib­lings, spous­es, ances­tors, and direct descen­dants.

Sum­ma­ry

Acquir­ing replace­ment prop­er­ty from a relat­ed par­ty in a 1031 exchange is pro­hib­it­ed, though excep­tions exist. A quick ref­er­ence to IRC § 267(b) can often clar­i­fy pro­hib­it­ed rela­tion­ships, but deep­er analy­sis might be required. Giv­en the com­plex­i­ties involved, seek­ing ear­ly advice from pro­fes­sion­al advi­sors is cru­cial to ensure com­pli­ance and achieve full tax defer­ral in a 1031 exchange.

Investor Dis­clo­sure:

DST’s (Delaware Statu­to­ry Trusts) are for accred­it­ed investors only.  Please us for addi­tion­al details on how a DST may be a solu­tion to your §1031 and §1033 Exchange and com­pli­ment your finan­cial objec­tives. 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.

DST News would like to acknowl­edge the con­tri­bu­tion of con­tent by Four Springs Cap­i­tal, Madi­son Cap­i­tal Group and Cap­i­tal Square to the arti­cle.  These com­pa­nies are Delaware Statu­to­ry Trust (DSTs) spon­sors that pro­vide replace­ment solu­tions for finan­cial advi­sors to con­sid­er for §1031 and §1033 exchanges.

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, in any form, 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.