Avoid Tax Pitfalls on 1031 Exchanges with Related Parties

tax pitfalls

If you have a hard time finding a buyer for investment or commercial real estate, there may be an alternative that meets your needs and saves you taxes. Instead of selling the property, consider exchanging it for a comparable property you have had your eye on.

The tax on this like-kind exchange is generally deferred under Section 1031 of the tax code if you meet certain requirements. But be aware — there are certain tax pitfalls if you swap properties with a related party.

Basic premise: When you arrange a like-kind exchange, you pay no current tax, except to the extent you receive any cash or other “boot” as part of the transaction. For instance, a reduction or elimination of the assumption of a mortgage is treated as boot for tax purposes. In that case, you are taxed on your gain up to the boot amount. Otherwise, you pay no taxes until you sell the replacement property — if ever.

To qualify as a like-kind exchange, the property you are relinquishing and the property you’re acquiring must be investment or business property. You generally can’t swap such personal property as a home under Section 1031. In addition, you must meet two specific deadlines (see right-hand box).

Of course, it’s not likely that both you and another real estate owner can agree on like-kind properties to exchange. As a result, these arrangements may involve multiple parties. You may also use a qualified intermediary specializing in 1031 exchanges to help complete the deal.

Important: Special rules can affect like-kind exchanges between related parties. For example, say you transfer real estate to a related party who disposes of the property within two years. In that case, the initial transfer does not qualify for tax-deferral treatment, so you must realize a gain or loss from the exchange.

The tax law definition of related parties is broad. As you might expect, it includes immediate family members such as spouses, parents, children, siblings and grandparents and grandchildren. But it also includes an individual and a corporation in which the individual owns, either directly or indirectly, more than 50 percent of the company’s outstanding stock. The definition also covers various related business entities and trusts.

To further complicate matters, the arrangement will not qualify for tax deferral if a primary motive is to avoid tax consequences. One court case involving a four-way exchange illustrates that the related party rules apply even when a qualified intermediary is used as a facilitator (Ocmulgee Fields, Inc., CA-11, No. No. 09-13395, 8/13/10).

Facts of the case: Ocmulgee Fields, an S Corporation in Georgia, sold a commercial property to qualified intermediary Security Bank of Bibb County. In return, Ocmulgee Fields acquired property from Treaty Fields, a related S corporation. The fourth participant was the McEachern Family Trust, an unrelated party.

As a result of the exchange, the owners of Ocmulgee Fields paid a 15 percent tax amounting to about $171,000 on a relatively small portion of gain. Otherwise, the tax would have been assessed at the 35 percent rate on a larger portion of gain, resulting in tax liability of more than $2 million.

But the IRS and the U.S. Tax Court claimed that the primary motive behind the arrangement was to avoid paying taxes. The 11th Circuit Court agreed and the tax deferral was voided. The circuit court cited the combination of three key factors:

  • Ocmulgee Fields and Treaty Fields cashed in their low-basis property, but paid taxes as if they had cashed in their high-basis property.
  • Ocmulgee Fields and Treaty Fields significantly reduced their immediate taxes by engaging in the exchange.
  • Ocmulgee Fields and Treaty Fields realized immediate tax savings by shifting nearly the entire tax burden to the party with the lowest tax rate.

Lesson to be learned: Be especially careful for like-kind exchanges involving related parties. The rules are complex, but you can navigate around them with professional assistance.

Like-Kind Exchange Deadlines

The tax law requires you to meet these two deadlines to defer tax with a like-kind exchange:

– You must identify or actually receive the replacement property within 45 days of transferring legal ownership of the relinquished property.

– You must receive the title to the replacement property within the earlier of 180 days or your tax return due date (plus extensions) for the tax year of the transfer.

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