Related party transactions bear the most restricted exchange limitations under Section 1031 of the Internal Revenue Code. Under Section 1031(f)(1), a taxpayer exchanging like-kind property with a related person is disqualified from the nonrecognition provisions if, within 2 years of the date of the last transfer, either party disposes of the exchange property.

A "related person" means any person bearing a relationship to the taxpayer described in Sections 267(b) or 707(b)(1). This list is lengthy, and it is important to be aware of its extent due to the potential for problems. It includes members of a family, defined as brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants. A "related person" is a partnership in which the taxpayer owns, directly or indirectly, more than 50 percent of the capital or profits interest in such partnership. Also included in the definition is an individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual; two corporations which are members of the same controlled group; a grantor and a fiduciary of any trust; a fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts; a fiduciary of a trust and a beneficiary of such trust; a fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts; a fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust; a person and an educational and charitable organization exempt from tax which is controlled directly or indirectly by such person or by members of the family if such person is an individual; a corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital interest, or the profits interest, in the partnership; an S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation; an S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or, an executor of an estate and a beneficiary of such estate (except in the case of a sale or exchange in satisfaction of a pecuniary bequest).

The purpose of the Section 1031(f) limitations, adopted in 1989, is to prevent abuse of the Section to avoid tax by exchanging high basis property for low basis property and cashing out. Congress determined that transactions between related persons and controlled entities offered the most potential for basis shifting and loss acceleration. Therefore, the Code now treats related parties as if they were the same as the taxpayer. In the case of a related party, a sale of exchange property within two years is treated as a cash out by the taxpayer. In a recently released Revenue Ruling the Service asserts that a taxpayer who transfers relinquished property to a qualified intermediary in exchange for replacement property transferred from a related party that receives cash or other non like-kind property for the replacement property is not entitled to nonrecognition treatment under Sec. 1031(a). This determination is found in Rev. Rul. 2002–83, 2002–49 I.R.B., 927, released December 9, 2002.

The facts presented in the Ruling are as follows:

"Individual A owns real property (Property 1) with a fair market value of $150x and an adjusted basis of $50x. Individual B owns real property (Property 2) with a fair market value of $150x and an adjusted basis of $150x. Both Property 1 and Property 2 are held for investment within the meaning of § 1031(a). A and B are related persons within the meaning of § 267(b). C, an individual unrelated to A and B, wishes to acquire Property 1 from A. A enters into an agreement for the transfers of Property 1 and Property 2 with B, C, and a qualified intermediary (QI). QI is unrelated to A and B.

Pursuant to their agreement, on January 6, 2003, A transfers Property 1 to QI and QI transfers Property 1 to C for $150x. On January 13, 2003, QI acquires Property 2 from B, pays B the $150x sale proceeds from QI’s sale of Property 1, and transfers Property 2 to A."

The Service sets out all of the relevant provisions of the Code and regulations in the ruling. Of particular interest to this discussion it notes that "Under § 1031(d), the basis of property acquired in a § 1031 exchange is the same as the basis of the property exchanged, decreased by any money the taxpayer receives and increased by any gain the taxpayer recognizes."

"Section 1.1031(k)–1(g)(4) allows taxpayers to use a qualified intermediary to facilitate a like-kind exchange. In the case of a transfer of relinquished property involving a qualified intermediary, the taxpayer’s transfer of relinquished property to a qualified intermediary and subsequent receipt of like-kind replacement property from the qualified intermediary is treated as an exchange with the qualified intermediary."

"Section 1031(f) provides special rules for property exchanges between related parties. Under § 1031(f)(1), a taxpayer exchanging like-kind property with a related person cannot use the nonrecognition provisions of § 1031 if, within 2 years of the date of the last transfer, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. The taxpayer takes any gain or loss into account in the taxable year in which the disposition occurs. For purposes of § 1031(f), the term "related person" means any person bearing a relationship to the taxpayer described in § 267(b) or 707(b)(1)."

The Ruling then analyzes the purpose and legislative history of Section 1031(f). The ruling states that the Section "is intended to deny nonrecognition treatment for transactions in which related parties make like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. The legislative history underlying § 1031(f) states that ‘if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, "cashed out" of the investment, and the original exchange should not be accorded nonrecognition treatment.’ H.R. Rep. No. 247, 101^st Cong. 1^st Sess. 1340 (1989). To prevent related parties from circumventing the rules of § 1031(f)(1), § 1031(f)(4) provides that the nonrecognition provisions of § 1031 do not apply to any exchange that is part of a transaction (or a series of transactions) structured to avoid the purposes of § 1031(f)(1)."

The Service notes further that the legislative history underlying § 1031(f)(4) provides: "If a taxpayer, pursuant to a pre-arranged plan, transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within 2 years of the previous transfer in a transaction otherwise qualifying under section 1031, the related party will not be entitled to nonrecognition treatment under section 1031. Id. at 1341."

The Ruling makes it clear that using a QI does not salvage a transaction that would not otherwise qualify. Tying the legislative history to the facts giving rise to the ruling, the Service determines that "if an unrelated third party is used to circumvent the purposes of the related party rule in § 1031(f), the nonrecognition provisions of § 1031 do not apply to the transaction. In the present case, A is using QI to circumvent the purposes of § 1031(f) in the same way that the unrelated party was used to circumvent the purposes of § 1031(f) in the legislative history example. Absent § 1031(f)(1), A could have engaged in a like-kind exchange of Property 1 for Property 2 with B, and B could have sold Property 1 to C. Under § 1031(f)(1), however, the non-recognition provisions of § 1031(a) do not apply to that exchange because A and B are related parties and B sells the replacement property within 2 years of the exchange. Accordingly, to avoid the application of § 1031(f)(1), A transfers low-basis Property 1 to QI who sells it to C for cash. QI acquires the high-basis replacement property from B and pays B the cash received from C. Thus, A engages in a like-kind exchange with QI, an unrelated third party, instead of B. However, the end result of the transaction is the same as if A had exchanged property with B followed by a sale from B to C. This series of transactions allows A to effectively cash out of the investment in Property 1 without the recognition of gain." The determination finds that "A’s exchange of property with QI, therefore, is part of a transaction structured to avoid the purposes of § 1031(f) and, under § 1031(f)(4), the non-recognition provisions of § 1031 do not apply to the exchange between A and QI. A’s exchange of Property 1 for Property 2 is treated as a taxable transaction." Section 1031(f)(4) might be described as a codification of the step transaction doctrine which allows the Service to ignore form over the substance of a series of transactions that would serve no substantial business purpose other than tax avoidance.

This conclusion is also predicated on the tax treatment of related persons as one taxpayer. Obviously, A does not actually receive any cash under these facts. Yet, A is treated as if the cash were paid directly. Applying Section 1001(a) to the facts of the ruling, the Service notes that "A has gain of $100x, the difference between A’s amount realized on the exchange ($150x, the fair market value of Property 2) and A’s adjusted basis in the property exchanged ($50x)". This might result in a very unfortunate financial crisis where the transaction was at arm’s length and A, not receiving money, does not have sufficient resources to pay the tax liability.

This ruling presents several pitfalls that real property practitioners should be careful to avoid. Closely held business entities owned by a related person present a particularly insidious trap for the unwary. Whenever replacement property is being conveyed by an unfamiliar business entity, it is incumbent upon the attorney structuring a closing involving a Section 1031 exchange to inquire as to whether the owners may be related persons as defined by the Code. Surnames can be deceptive due to marital relationships therefore, owners may not be obviously related. The Ruling implicitly acknowledges that related parties may exchange properties in a qualified transaction as long as cash or non like-kind property is not received. This offers another pitfall where property may not qualify once transferred to the related party due to its being categorized as "inventory". If the related person is a developer, lot held for investment by the taxpayer may be considered inventory for the related person. This would be treated as a payment of a cash equivalent instead of an exchange of like-kind property. Under this Ruling, the exchange would not qualify even though transacted through a qualified intermediary.

This determination does not address, directly or implicitly, essentially the same fact situation but varied where the related person’s basis in the property is also low or where the taxpayer has a relatively high basis. The rationale behind Section 1031(f)(4) would lead one to a logical conclusion that the exchange should qualify for deferral of gain for the taxpayer since the related party will be taxed on the gain realized from the transfer of the replacement property and the opportunity for abuse is not present. Prudence would dictate that the ruling be interpreted literally and one should assume that all transactions involving a related party that receives cash or non-like-kind property will not qualify for deferral of gain or loss until clarified by a future determination. In a similar issue, conventional wisdom in the exchange industry holds that a sale to a related party through a QI with replacement property acquired from an unrelated party is not disqualified by Section 1031(f) upon a subsequent sale of the relinquished property by the related person within two years. While there is no definitive answer the reasoning was that since the taxpayer is not receiving property from a related party, there is no application of Section 1031(f). The wording of the subsection analyzed in light of this new ruling casts some doubt on that conclusion.