714 / How is a like-kind exchange between related parties taxed?

Editor’s Note: For tax years beginning after 2017, the nonrecognition treatment provided under IRC Section 1031 is limited to exchanges of real property that is not held primarily for sale.¹ This provision applies to exchanges occurring after December 31, 2017. An exception existed if either: (1) the property involved in the exchange was disposed of on or before December 31, 2017, or (2) the property received in the exchange was received on or before December 31, 2017.² The new rules also provide that real property located within the U.S. and foreign real property are not of a like-kind.³

If a like-kind exchange that results in nonrecognition of gain or loss occurs between related parties, followed by a disposition of either property within two years of the date of the last transfer that was part of the like-kind exchange, then the original transaction will not qualify for nonrecognition treatment.⁴ For purposes of this rule, the term “disposition” does not include dispositions resulting from the death of the taxpayer or (if earlier) the related person. The two-year disposition rule also will not apply to involuntary conversions, so long as the exchange occurred before the threat or imminence of the conversion. An exception is also provided where it can be established that neither the exchange nor the subsequent disposition had as its principal purpose the avoidance of income tax.⁵

“Related persons,” for purposes of this rule, include the following: (1) members of the same family (i.e., brothers, sisters, spouses, ancestors and lineal descendants); (2) an individual and a corporation of which the individual actually or constructively owns more than 50 percent of the stock; (3) a grantor and a fiduciary of a trust; (4) fiduciaries of two trusts if the same person is the grantor of both; (5) a fiduciary and a beneficiary of the same trust; (6) a fiduciary of a trust and a beneficiary of another trust set up by the same grantor; (7) a fiduciary of a trust and a corporation of which the grantor of the trust actually or constructively owns more than 50 percent of the stock; (8) a person and an IRC Section 501 tax-exempt organization controlled by the person or members of his family (as described in (1) above); (9) a corporation and a partnership if the same person actually or constructively owns more than 50 percent of the stock of the corporation, and has more than a 50 percent interest in the partnership; (10) two S corporations if the same persons actually or constructively own more than 50 percent of the stock of each; (11) an S corporation and a C corporation, if the same persons actually or constructively own more than 50 percent of the stock of each; (12) a person and a partnership of which the person actually or constructively owns more than 50 percent of the capital interest or profits interest; (13) two partnerships if the same persons actually or constructively own more than 50 percent of the capital interest or profits interest of each; or (14) generally, an executor and a beneficiary of an estate.⁶

Any transaction, or series of transactions, structured to avoid the related party rules for like-kind exchanges will not qualify for nonrecognition treatment.⁷ The Service has ruled that a taxpayer who transfers relinquished property to a qualified intermediary for replacement property formerly owned by a related party is not entitled to nonrecognition treatment under IRC Section 1031(a) if, as part of the transaction, the related party receives cash or other nonlike-kind property for the replacement property.⁸ If the risk of holding any property is substantially diminished by a short sale, by the holding of a put option, or by another person holding a right to acquire the property, then the running of the two-year period will be suspended during the period that the option or other right is held.⁹