Related party 1031 exchanges

Your related party exchange is subject to a rule that can undo nonrecognition treatment after the exchange. Section 1031(f)(1) applies when you exchange property with a related person and your exchange would otherwise qualify for nonrecognition under section 1031, determined without regard to this subsection. A subsequent disposition of the relevant property within the specified period can cause your original exchange to lose that treatment.

Your own disposition is one possible trigger. The other is a disposition by the related person of the property you transferred. For your disposition, the statute identifies the property you received from the related person that was of like kind to the property you transferred. These are alternative triggers. The rule does not require both you and the related person to dispose of the exchanged properties.

You can also encounter this issue in an indirect exchange. The IRS describes the rule as applying when a like kind exchange takes place directly or indirectly between related persons and either party disposes of the property within two years after the exchange. Under that description, each person must report any gain or loss not recognized on the original exchange.

For the statutory disposition rule, your reference date is the date of the last transfer forming part of the exchange. The rule reaches a specified disposition occurring before the date two years after that last transfer. Its wording therefore ties the period to the final transfer that was part of your exchange.

If your exchange involves transfers on different dates, the statute still uses the last transfer forming part of the exchange. An earlier transfer does not replace that reference date. The relevant comparison is between the disposition date and the date two years after the last exchange transfer.

Your two year period concerns both sides of the exchange. Keeping the property you received does not, by itself, prevent this rule from applying if the related person disposes of the property you transferred within the specified period. Likewise, the related person keeping your former property does not prevent your own disposition from triggering the rule. The statutory exceptions can exclude certain dispositions from this analysis.

If your exchange loses nonrecognition treatment because of section 1031(f)(1), you take the resulting gain or loss into account as of the date of the triggering disposition. The statute expressly connects recognition to that later event. Your recognition date under this rule is therefore the disposition date, even though the gain or loss arose from the earlier exchange.

The consequence for you is not limited to gain. The statutory language covers gain or loss recognized because of the related party rule. Under the IRS description, you and the other participant must each report previously deferred gain or loss following either participant's disposal within two years of a direct or indirect related person swap.

Section 1031(f)(2) identifies three categories of dispositions that you do not take into account for the disposition test in paragraph (1)(C). Each category has its own conditions. These exceptions address whether a disposition counts for that test, rather than replacing the requirement that your exchange otherwise qualify for nonrecognition treatment.

For your compulsory or involuntary conversion exception, identifying a conversion within section 1033 is only part of the statutory condition. Your exchange must also have occurred before the threat or imminence of that conversion. The exception's wording does not omit that timing requirement when the later disposition is compulsory.

For your tax avoidance exception, the statutory standard is whether avoidance of Federal income tax was one of the principal purposes. The condition is not limited to whether tax avoidance was the sole purpose. It also requires the necessary showing to the Secretary's satisfaction, covering both your exchange and the disposition.

Under section 1031(d), your basis in property acquired in a covered exchange starts with the basis of the property you exchanged. You decrease that amount by money you receive. You increase it by gain you recognize on the exchange, or decrease it by loss you recognize on the exchange.

This calculation connects your basis in the property received to your basis in the property transferred. The statutory starting point is the exchanged property's basis, followed by the stated adjustments for money and recognized gain or loss. Fair market value has a separate role when you receive a mixture of qualifying property and other property.

If you receive both property permitted to be received without recognition under the listed exchange provisions and other property, you allocate the resulting basis among the properties received other than money. For this allocation, you assign the other property an amount equal to its fair market value on the exchange date. The rule therefore specifies both the property included in the allocation and the valuation date.

Your liability can also affect the money received adjustment. For section 1031, another party to the exchange assuming your liability, as determined under section 357(d), is treated as money you receive when the assumption is part of your consideration in the exchange. The condition concerns an assumption of your liability as part of that consideration.

The supplied regulation example shows how your exchange group basis can reflect several adjustments. In that example, the aggregate adjusted basis of property transferred is increased by recognized gain, the exchange group surplus, and allocated excess liabilities assumed. Because the group receives only real estate R, the entire resulting basis is allocated to that property.

A separate supplied regulation example shows your allocation when an exchange group receives two real estate assets. You calculate the received assets' basis by adding recognized gain to the transferred assets' adjusted basis, then subtracting the group's deficiency. The resulting basis is allocated between the received assets in proportion to their fair market values.