Raby & Raby on Related Party § 1031 Exchanges

Burgess J.W. Raby & William L. Raby have published Related Parties, Tax-Deferred Sales, and Cashing Out, also available on the Tax Analysts web site as Doc 2005-3174, 2005 TNT 32-162. Here is the Conclusion:

Section 1031 exchanges between related parties are permitted, but the tax practitioner needs to think through the details to avoid unexpected consequences. The lesson of the Teruya opinion is that if the effect of what happened in a multiparty exchange is the same as if an exchange had occurred between related parties, the mere fact that unrelated parties were involved, especially when involved as qualified intermediaries, will not change the outcome. If either related party to the exchange disposes of the property received within two years, there is a probability that the IRS will take the position that the original exchange is thereby rendered taxable as of the date of that disposition. The TP can still keep the original tax-free treatment if it can be established that avoidance of federal income taxes was not a principal purpose of both the original exchange and the subsequent disposition of the property.

The tax practitioner involved with that related-party transaction therefore needs to focus on documenting the absence of federal income tax avoidance motives. In turn, TPs need to be cautioned of the tax danger of either property being disposed of within the two-year period. Form 8824, the like-kind exchange reporting form, is useful in that regard. Part I asks whether a related-party exchange occurred and Part II asks for additional information covering current related-party exchanges and those of the prior two years. The tax practitioner also needs to be sensitive to the possibility that a related-party exchange may have occurred indirectly -- such as through the use of a qualified intermediary -- and focus when analyzing the transaction on not only the nature of the property being acquired as replacement property but also on the identity of the person from whom it is being acquired. Section 1031(f)(1) does not say "directly or indirectly" when describing TP exchanges with a related person, but Judge Thornton has so interpreted § 1031(f)(4) in his Teruya opinion as to impart "directly or indirectly" into those transactions covered by § 1031(f) by virtue of being structured to avoid that subsection. The Form 8824 questions ask about direct or indirect related-party transactions.

In any event, the valuation of properties involved in related-party exchanges needs to be better documented than often occurs. Related-party exchanges without subsequent dispositions often provide an avenue for the transfer of values from one party to another, such as in an exchange by Parent of Blackacre, with an actual FMV of $2 million, for Child's Whiteacre, which has an actual FMV of only $1.2 million even though its agreed value in the transaction is also treated as $2 million. In addition to improper valuations, of course, creation and exchange of fractional interests can also affect valuations, but legitimately. For example, H & W, owning real estate as separate property, can reduce the total value of that property by exchanging fractional interests between themselves and their children. If H dies owning 25% undivided interests in four equally valuable parcels of real estate, the estate tax valuation of his interests in real estate may be 25% to 40% less than if he had died owning 100% of one piece. Neither attribution nor aggregation rules generally apply when it comes to gift or estate tax valuation.