Over the years, there has been an unfortunate amount of abuse in terms of how commercial real estate investors have used 1031 exchanges. Much of this abuse has stemmed from investors completing an exchange transaction with a “related party”, such as a family member. The Internal Revenue Service (IRS) has issued special rules to help investors understand what is and is not allowed when completing a 1031 exchange. These rules are known as Related Party Rules.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers and often assist investors with the placement of their 1031 Exchange funds. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What is a 1031 Exchange?
A 1031 Exchange is a type of commercial real estate transaction that allows real estate investors to defer taxes on the profitable sale of an investment property (the “relinquished property”) as long as they reinvest the sale proceeds into a new property (the “replacement property”).
Rules for completing 1031 Exchanges are defined by the IRS in section 1031 of the Internal Revenue Code, and they must be complied with to the letter in order for investors to receive full tax deferral. The most important rules include:
- Investors have 45 days from the sale date of the relinquished property to formally identify a replacement property and 180 days to close on the purchase of it.
- The replacement property must be “like kind’ to the relinquished property. In general, most commercial rental property is like-kind to other commercial rental property. For example, a multifamily apartment building is like-kind to an office building or a retail center is like-kind to an industrial building. Generally, investors cannot use their primary residence, a property held for personal use, or a vacation home.
- Investors must reinvest all of the gain into a replacement property whose market value is equal to or greater than the relinquished property. If the investor receives any personal property or cash, this is known as “boot”, and it is taxable.
- Both the replacement property and the relinquished property must be located within the United States.
There are many more rules outlined in the internal revenue code so it is a good idea for investors to both read it carefully and work with a Qualified Intermediary – an expert in the rules who helps to facilitate the transaction. Doing so will help reduce the risk that some or all of the gain becomes taxable.
How Does a 1031 Exchange Work?
To illustrate how these rules come together, an example is helpful.
Suppose that a husband and wife bought a small retail property thirty years ago for $500,000. Over time the market has grown substantially and they are now near retirement age and would like to sell the property and they have an offer for $1.5MM. Rather than incur the taxes on the gain, they have decided that they would like to do a 1031 Exchange and reinvest the gain into another like-kind property.
So the first step is to get the property sold. Since they already have an offer for $1.5MM, this is easy. On the date that the sale closes, a clock starts ticking.
The next step is to find a suitable replacement property. The major requirement here is that it has to be “like kind” to the property that was sold and it has to be identified within 45 days of the sale date. Identification must be made in writing and it should contain the address of the property. Once identified, the couple has an additional 135 days (180 days total from the date of sale) to close on the sale of it.
At closing, there are a number of documents that must be complete and requirements that must be met to indicate that it was the taxpayer’s intent to complete a 1031 Exchange. The Qualified Intermediary will lead them through the entire process and help complete all of the paperwork needed to receive full tax deferral.
Now that we understand what a 1031 exchange is and how it works, let’s take a moment to talk about what a related party transaction is and why it matters in the context of a 1031 exchange.
Related Parties Defined in Exchanges
A related party 1031 transaction is a 1031 exchange completed between two related parties as defined by code sections 267(b) and 707(b)(1) of the Internal Revenue Code (“IRC”). Related parties can take on many forms according to the IRC, and a few of them include a related person (spouse, sibling, etc.), a lineal descendant, two corporations that are in the same controlled group, a grantor and a fiduciary of the same trust, and the list goes on. For the full list, see code section 267(b) and 707(b)(1) of the Internal Revenue Code (“IRC”).
It’s important to note that the related party can be an individual or an entity such as a partnership or corporation. When an investor transacts with an individual or party defined as a related party, then the investor is engaging in a related party exchange.
Can an Investor Do a 1031 Exchange to a Related Party?
The short answer is yes, but there are caveats that investors need to be aware of. Investors are allowed to complete an exchange of property with a related party as long as the rules set out by the IRS are followed.
Swapping Properties with a Related Party
When a property is swapped with a related party it means that the investor sells (relinquishes) property to the related party and purchases the replacement property from the related party. This is considered a tax-deferred exchange by the IRS as long as the investor holds the replacement property for at least two years after acquiring it. Let’s explore the two-year holding period more closely.
2-Year Holding Period on Properties
When an investor sells, or relinquishes, property to a related party or purchases a replacement property from a related party, the relevant party must hold the newly acquired property for at least two years. In fact, if the property is sold before the two-year holding period ends, the exchange will be disqualified and the sale of the relinquished property is at risk for becoming a taxable event.
It’s worth noting that there are three exceptions where a property does not need to be held for the two year timeframe.
- Death of the investor or the related party: If the investor (the person or entity responsible for selling the relinquished property to the related party and then purchasing the replacement property) dies, then the property may be sold before the end of the two year period. The same is true if the related party dies before the two year period ends.
- Involuntary conversion: If the investor or the related party is subject to an involuntary conversion before the end of the two year period, then the replacement property can be sold before the two year period ends. An involuntary conversion can come about for a few different reasons, including: the property is destroyed due to a natural disaster, the property is lost or seized through the eminent domain process, or the property is transferred because it is condemned.
- No avoidance of Federal income tax: Section §1031(f)(2)(C) allows for one additional exception to the two year rule. If it can be proven that the sale of the replacement property does not constitute the avoidance of income tax, then it may be allowed by the IRS. This is typically a difficult thing to prove because most 1031 exchanges are done for the purpose of deferring capital gains tax on a real estate investment.
Selling to or Buying from a Related Party
As discussed above, a swap with a related party is allowed under the federal tax code. It’s important to know that issues can arise when an investor buys a property from a related party or sells to a related party. Whether an investor is selling to a related party or completing the purchase of the replacement property from a related party, there are rules that the investor should be aware of. It’s important to start by understanding a concept called “basis shifting”.
Basis shifting occurs when a taxpayer defers the gain on low cost basis property by swapping it for a high basis property from a related party. The investor would then sell the newly acquired high basis property to an unrelated party without getting hit with much or any capital gain. This strategy is not what the IRS initially intended Section 1031 to allow, so further guidance was issued that impacts buyers and sellers dealing with related parties differently.
Let’s start with the case where the buyer of a replacement property purchases it from a related party seller. The IRS has issued additional guidance that basically disallows the purchase of replacement property from a related party seller unless the seller is also completing a 1031 exchange. Transactions that involve the purchase of replacement property from a related party are typically taxable events in the eyes of the IRS.
When the buyer of the relinquished property is a related party, there is a reduced risk of basis shifting, so according to the IRS, this is an allowable strategy for investors seeking to defer capital gains.
Can a Family Member Act as the Qualified Intermediary?
A Qualified Intermediary, sometimes referred to as an Accommodator or Facilitator, is an individual, entity, or financial institution, that assists in the facilitation of a 1031 Exchange. More specifically, a Qualified Intermediary is further defined in 26 CFR § 1.1031(k)-1(g)(4), which states that a Qualified Intermediary is a person who:
(A) Is not the taxpayer or a disqualified person (as defined in paragraph (k) of this section), and
(B) Enters into a written agreement with the taxpayer (the “exchange agreement”) and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.
Because family members are classified as “disqualified intermediaries” under 26 CFR § 1.1031, they cannot be named as the qualified intermediary for a 1031 like-kind exchange. For further information on how to select a qualified intermediary, see our article on it here.
Related Party 1031 Exchange Process
The most common, and most often allowed, example of a 1031 exchange between related parties is when a taxpayer sells a relinquished property to a related party and then acquires a replacement property from an unrelated party. Because the taxpayer is not shifting tax basis into the replacement property instead of the relinquished property, there is limited opportunity for related party tax abuse.
The process for completing a related party exchange is basically the same as any other 1031 exchange. After selling the relinquished property, the investor has 45 days to identify the replacement property and 180 days from the date of sale to complete the purchase of it. The transaction needs to meet the following key criteria to avoid tax liabilities (although there are additional criteria that investors should be aware of, which we discuss in greater detail here):
- Purpose: Both properties (the relinquished and replacement) must be held for use in a trade or business or for investment purposes. Property with a personal use, like a primary residence or vacation home, does not qualify for like-kind exchange treatment.
- Value and Equity: The value of the relinquished property and the equity in it must be the same as or greater than the replacement property. For example, if the relinquished property has a value of $1,000,000 and equity of $250,000, the replacement property must have a purchase price of at least $1,000,000 and equity of at least $250,000.
- Diversification: How many properties can you identify in a 1031 exchange? Properties do not necessarily have to be exchanged on a 1:1 basis. For individuals looking to diversify their investment portfolio, one property can be exchanged for many as long as the following rules are met:
- Rule of Three: The exchanger can identify up to 3 like kind replacement properties
- 200% Rule: The exchanger can identify unlimited properties as long as their cumulative value does not exceed 200% of the market value of the relinquished asset.
- 95% Rule: The exchanger can identify more than three properties whose value exceeds 200% so long as they acquire 95% of the value of the replacement properties.
- Like Kind: Finally, and perhaps most importantly, the replacement property must be “like kind” to the relinquished property.
Summary of 1031 Exchange Related Party Rules
A 1031 Exchange, named after a section in the Internal Revenue Code, is a type of transaction that allows investors to defer capital gains taxes on a profitable sale as long as the proceeds are “exchanged” into another property of like-kind. A related party 1031 transaction is a 1031 exchange completed between two related parties as defined by code sections 267(b) and 707(b)(1) of the Internal Revenue Code (“IRC”). Investors are allowed to complete an exchange of property with a related party as long as the rules set out by the IRS are followed. It is critical that investors and property owners consult with a tax advisor before attempting to undertake a 1031 exchange with a related party because the financial consequences of getting it wrong can be steep.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.