Related-Party Exchanges: Proceed With Caution

	By Yunna Barats Co-Partner In-Charge Real Estate Group barats@rbz.com
Publication Date: Spring 2004
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 Internal Revenue Code (IRC) Section 1031, governing the taxdeferred exchanges of “like-kind” property, allows transactions between related parties. Not unexpectedly, however, IRC Section 1031 places some additional restrictions on related-party exchanges.

Who are related parties? Besides the obvious family members, the list includes (but is not limited to) entities under common control (directly or indirectly), the owner and the entity he or she controls, a grantor and a trust beneficiary or a fiduciary and a beneficiary of the same trust. Therefore, if you are planning an exchange with an entity in which you are holding an interest, consider whether you and the entity in question are related. If so, you may be subject to the additional restrictions discussed below.

Let’s examine these additional restrictions burdening relatedparty exchanges. In addition to all other like-kind exchange rules, the related-party exchanges are subject to two major requirements: the holding requirement and the lack of tax avoidance requirement.

The holding requirement is relatively straightforward. In order to qualify for non-recognition treatment, the properties received in a related-party like-kind exchange transaction must be held by the related parties involved for at least two years. The two-year period runs from the date of the last transfer. If the property is disposed of before the expiration of the two-year period, the transaction is treated as a taxable sale.

It is worth noting that certain dispositions are exempt from the two-year holding requirement. Such dispositions are:

1. A disposition following the death of a taxpayer who was involved in a related-party exchange.

2. A disposition in a compulsory or involuntary conversion. However, in order to take advantage of this exception, the taxpayer must show that the like-kind exchange occurred before the threat or imminence of the conversion.

In addition, the IRS has privately ruled that a subsequent disposition does not include a transfer to the recipient’s grantor trust. The rationale behind this ruling is that this type of transfer is not a disposition because it is deemed a mere change of form of the interest in the property and not a relinquishment of such interest. The IRS warned, however, that a subsequent disposition of the property by the trust or termination of the trust’s status as a grantor trust, within two years of the like-kind exchange by the related parties, may trigger the gain.

It appears that following the same logic, a transfer of the property received in a related-party like-kind exchange to a single member LLC should not trigger the recognition of gain. However, a subsequent conversion of a single member LLC to a regular LLC with multiple members within the prescribed period will most likely violate a holding requirement.

The second additional requirement imposed on related-party exchange transactions is not as straightforward as the first. Nonrecognition treatment under the like-kind exchange rules will not apply to any exchange that is a part of a transaction (or a series of transactions) intended to avoid the application of these related-party rules (the “anti-avoidance” provision). Since this is not a mechanical test and there is no detailed regulatory guidance regarding the application of this rule, facts and circumstances in each case must be examined.

The IRS has recently ruled that the anti-avoidance provision applies to an attempted exchange involving related parties through the use of a qualified intermediary. A taxpayer who transfers relinquished property to a qualified intermediary in exchange for replacement property (formerly owned by a related party) is not entitled to non-recognition treatment if, as part of the transaction, the related party receives cash or other non-like-kind property for the replacement property.

Each related-party exchange should be carefully planned and all surrounding facts and circumstances must be examined in order for the transaction to withstand potential IRS scrutiny.