Like-Kind Exchanges – The Related Party Rule and a Planning Opportunity

Overview

The like-kind exchange rules of I.R.C. §1031 have restrictions that can apply when related parties are involved.  One of those restrictions is a two-year rule.  The rule applies when related parties engage in an exchange, and results in the tax-deferred benefit of the transaction being lost if the property exchanged of is disposed of within two years.

So, who are “related parties” for purposes of the two-year rule?  Can the related party rules create an issue with an estate plan?  For instance, if an estate plan for a married couple establishes a trust for the surviving spouse with the surviving spouse receiving the income from trust property for life and the remainder passing to the children, will the children be able to exchange their interests so that at least one child can receive money for their interest without triggering immediate gain? 

Today’s post takes a look at the related party rules in the context of like-kind exchanges and the potential impact on traditional estate plans. 

Related Party Rules

General rule.  Under I.R.C. §1031(a)(1), no gain or loss is recognized on the exchange of property that is held for productive use in a trade or business or for investment if the property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.  If the exchange occurs between “related parties,” a two-year rule applies. I.R.C. §1031(f)(1)(C).  Under that rule, non-recognition treatment is lost if the related party with which like-kind property is exchanged disposes of the property within two years of the exchange.   I.R.C. §1031(f)(1)(A)-(C).  The two-year holding period starts running on the date of the transfer or conveyance of the last property involved in the exchange.  

Exceptions.  There are exceptions to the two-year rule for: (1) transfers that occur after the taxpayer’s death or the related party’s death; (2) transfers that occur due to an involuntary conversion, and; (3) transfers that do not involve tax avoidance as the purpose of the transfer. I.R.C. §1031(f)(2). There is also a “suspension” provision in I.R.C. §1031(g). Under that provision, the two-year holding period is suspended if either the taxpayer’s or the related party’s risk of loss is substantially decreased (due to an option, put, short sale or other transaction). Once the risk of loss ceases, the two-year period continues from the point where it stopped.

Definition of “related parties.”  I.R.C. §1031(f)(3) defines “related party” by routing the answer through I.R.C. §§267(b) or 707(b)(1). Under those provisions, related persons to the taxpayer are:

• Brothers and sisters (whether whole or half-blood)
• The taxpayer’s spouse, ancestors, lineal descendants
• Certain types of entity relationships – a corporation, limited liability company or partnership and a person that owns (directly or indirectly) more than 50 percent of the stock, membership interests or partnership interests or more that 50 percent of the capital interests or profits interests, and two partnerships in which the same persons owns (directly or indirectly) more than 50 percent of the capital or profits interests
• Two entities in which the same individuals own directly or indirectly more than 50 percent of each entity
• An estate in which the taxpayer is either the executor or beneficiary of the estate
• A trust in which the taxpayer is the fiduciary and the related party is a beneficiary either of that trust or a related trust or a fiduciary of a related trust

Related parties, however, do not include step-parents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.

Related Party Scenarios

It is possible for a taxpayer to relinquish property to a related party and acquire like-kind replacement property from a non-related party without violating the I.R.C. §1031 exchange related party rules.  The related parties must each hold their respective properties for a minimum of two years.  The deferral rules also apply when property is acquired from a related party and the related party then completes a separate tax-deferred exchange transaction using the sales proceeds from the sale of the related party's property that was received in the initial exchange. 

Related party transactions will also be respected if a “basis swap” is not involved.  See, e.g., Priv. Ltr. Rul. 200810016 (Dec. 6, 2007).

The exchange of interests in real estate among related parties can also qualify under the rules. In Rev. Rul. 73-476,9 IRS ruled that exchanges of undivided interests in multiple parcels of real estate for 100 percent ownership of one or more parcels of the same real estate qualify as valid like-kind exchanges. In addition, IRS has also ruled that an exchange of partial interests in two parcels of property between related persons, followed by the sale of one of the parcels to an unrelated party within two years, qualified for non-recognition of gain.  Priv. Ltr. Rul. 200730002 (April 26, 2007).  

Estate Planning Implications

The related party rules can apply after the implementation of common estate plans.  For example, assume that Jimmy owns farmland that he transfers to a trust for his wife, Beulah. The trust terms specify that if Beulah survives Jimmy, she is to receive the income from the farmland for life with the farmland passing upon her death to their three children equally.  Beulah survives Jimmy, and on her subsequent death the farmland is transferred to the children with each child owning an undivided one-third interest in the farmland as tenants in common.  Each of the children then deeds their respective undivided interests to their own grantor trust. One child farms his undivided one-third interest that is held in his trust, and also serves as a co-trustee of his trust.  One child dies, and her undivided one-third interest remained in her trust with the trust income payable to her surviving spouse for life and the remainder interest passing to her children (nieces and nephews of her siblings).  The third child continues to hold his undivided one-third interest in trust and farms with it. 

Thus, after the one child’s death, the ownership of the farmland is as follows: (1) a one-third undivided interest by a farming child held via his trust; (2) a one-third undivided interest held in trust by another farming child; and (3) a one-third undivided interest in trust split equally among the children of the deceased child subject to a life income interest in that child’s surviving spouse.  The co-trustees of this last trust were the deceased child’s surviving spouse and their two children.  They have no care for the farmland, and would like to liquidate their one-third ownership interest in the farmland.  The two sons of Jimmy and Beulah wish to continue farming the land that they hold in their trusts. 

After visiting with their legal and tax counsel to determine a way to allow the two sons to continue farming and allow their niece and nephew to liquidate their interest, and do so in a tax efficient manner, a solution is proposed.  The solution is to have the three trusts exchange each of their undivided one-third interests in the farmland for 100 percent fee simple (outright ownership) interests in the same farmland.  The exchange will be based on surveys and appraisals that will result in a three-way split of equal value.  There will be no liabilities assumed, and none of the trusts will receive money or other property in the exchange.  The exchange will be straight-up.  The only difference among the trusts is that the one-third farmland interest in the deceased daughter’s trust will have a higher income tax basis because of her death and the resulting step-up in basis to fair market value at that time.  After the exchange, the daughter’s trust will sell its parcel to a third party for cash, and the two sons of Jimmy and Beulah will continue to farm their tracts.

The IRS has blessed this type of a scenario.  In PLRs 200919027 (Feb. 3, 2009) and 200920032 (Feb. 3, 2009), the IRS said that the related party rule of I.R.C. §1031(f) didn’t apply and the gain from the sale by the niece and nephew of their parcel within two years of the exchange was deferrable.  The two sons were not related parties to their sister’s trust or its trustees (her surviving spouse and children).  The related party rule would apply, however, if either of the two brothers would sell their respective tracts within two years of the initial exchange. 

Conclusion

The related party rules are important provisions in like-kind exchange transactions. With respect to real estate swaps, proper estate planning techniques can be utilized to achieve the desired result.  The use of a like-kind exchange in a situation such as that presented above is a much better solution than a partition and sale of the property.  It’s one way to get cash into the hands of a non-farm heir without disrupting the farming operation, and doing so on a tax-deferred basis.