Special rules govern 1031 exchanges between related parties, and running afoul of them can turn your tax-free exchange into a taxable sale.
Here is an example:
Brad and Ellis are brothers. Brad lives in Dallas, Texas, where they grew up, and Ellis lives in a suburb of Boston, where he settled after law school. As a result of an inheritance from their grandparents, Brad and Ellis own several houses in Dallas as joint tenants.
They have rented these houses to tenants and divided the expenses and the profits equally between themselves. The largest of these houses is a five bedroom ranch style home sitting on 3.5 acres.
Brad now wants to move into this house, and wants Ellis to sell him his one-half ownership so that Brad can own the house on his own. The house’s fair market value at the time of their inheritance was $600,000. Its current fair market value is $950,000.
Ellis points out to his brother that if he sells his share of the house to Brad, he will be required to pay capital gains taxes of approximately $45,000. Instead, Ellis proposes that they do a Section 1031 exchange, in which he and Brad would swap their portions of ownership of several of the properties that they own together.
Specifically, Ellis proposes that Brad exchange his joint ownership portion of two of their smaller properties with a combined current fair market value of $890,000 for the ranch house property worth $950,000 that Brad wants. Once Ellis has sole ownership of these properties, Ellis plans to remodel and sell them within the next two years.
Does Ellis’ proposal make sense?
What about the $60,000 difference in value between the property that Ellis wants to exchange in return for the ranch house?
Are there any special problems for the brothers to consider, and is there anything that they could do to avoid these problems?
The first point to recall here is that special rules apply to Section 1031 exchanges with anyone who is a “related party” to the taxpayer.
Related parties include family members, such as spouses and lineal descendants (parents and children, brothers, sisters, grandparents and grandchildren), as well as corporations, partnerships, trusts, and estates in which a related person owns more than 50 percent either directly or indirectly.
You can engage in a Section 1031 exchange with these related parties, but only if neither the relinquished property nor the replacement property is sold or otherwise disposed of within two years of the transfer.
The IRS monitors exchanges between related parties by requiring that both parties file a special tax form, Exchange Form 8824, in the year of the exchange and for the next two years.
In this example, Brad and Ellis can exchange properties, but the exchange will be treated as a taxable sale if either the relinquished property or the replacement property is sold or otherwise disposed of within two years of the transfer.
Thus, if either Brad or Ellis sells or otherwise disposes of the property involved in the exchange within two years of the transfer, the IRS will retroactively disqualify the original transaction as a Section 1031 exchange and order that capital gains taxes be paid.
Moreover, if either brother sells or disposes of the property before the two year holding period is over, the other brother will be required to pay capital gains taxes on the transaction even though he was not the party who sold or disposed of the exchanged property.
Here, if Ellis carries out his plans to remodel and sell the property he receives in the exchange within the next two years, the IRS will retroactively declare the exchange to be a taxable sale and both Ellis and Brad will be required to pay capital gains taxes.
Accordingly, Brad should consider doing the exchange only if Ellis agrees, in the written documents controlling the exchange, to a provision specifying that if either party triggers the taxation of gain within the two year holding period, the innocent party will be reimbursed for the adverse tax consequences.
In addition, a transaction to qualify as a Section 1031 exchange, both the relinquished and the replacement properties must be held for use in a trade or business, or for investment. In this example, Brad wants to move into one of the exchanged properties and use it as a personal residence.
If he does so, the property is not held for use in a trade or business, or for investment, and the transaction will not qualify as a Section 1031 exchange. Brad can move into the five bedroom ranch style home only after a prudent holding period of at least two years, during which he uses the property in a trade or business or for investment.
Brad should also be concerned about the $60,000 difference in fair market value between the property he will be giving up and the property he will receive in the exchange.
In order to use Section 1031 to avoid paying any capital gains taxes, the basic rule is to exchange up, never down.
Here, if the exchange were to go forward as Ellis proposes (that is, Brad would receive property with a fair market value of $890,000 in exchange for property with a fair market value of $950,000), then Brad will have a capital gain of $60,000 on which he will required to pay capital gains taxes.
To contact Melissa J. Fox about serving as a qualified intermediary, attorney, or broker, or for other 1031 exchange, legal, or real estate services , send an email to firstname.lastname@example.org