1031 Exchanges. Recent Related Party Letter Rulings
By Lawrence Gordon
January 23, 2008
A series of recent private letter rulings by the Internal Revenue Service has
clarified some of the more complex and troubling issues regarding related-party
exchange transactions under Section 1031.
Under Section 1031(a), no gain or loss is recognized on an exchange of like-kind
property held for productive use in a trade or business or for investment. If a
like-kind exchange involves a related person, however, additional requirements
under Section 1031(f) must be satisfied if the transaction is to qualify for tax
Under Section 1031(f), the exchanged property must be held for a period of at
least two years unless certain exceptions under Section 1031(f)(2) apply.
Additionally, the transaction must not involve a series of indirect exchanges
that violate the provisions of Section 1031(f)(4).
The stricter requirements on related-party exchanges stems from Congress’
finding that they are inherently subject to abuse. In particular, Section
1031(f) prevents related persons from acting as mere “conduits” for exchanging
like-kind properties with the aim of “cashing out” by improperly shifting basis
from higher basis property to lower basis property in anticipation of a sale of
the formerly lower basis property. Basis shifting and cashing out are abuses
that Section 1031(f) was designed to prevent.
The requirements of Section 1031(f) add an overlay of complexity to
related-party exchanges in addition to the requirements of standard exchanges
under Sections 1031(a) and, as a result, have discouraged the use of exchanges
between related persons that could result in legitimate tax savings.
In the first private letter ruling, Taxpayer exchanged a fractional 25% interest
in one property with related-parties for a 100% interest in another. The fair
market value of both the relinquished and replacement properties were
equivalent. Although the transaction involved related-persons under Section
1031(f)(1), the IRS did not disqualify the non-recognition provisions of Section
1031(a) in this case because there was no impermissible basis-shifting that
would trigger the anti-abuse provisions of Section 1031(f)(4). (LTR. RUL.
In the second case, Taxpayer sold property for cash to a related-party that did
not own real estate but that planned to sell the relinquished party within the
two year look-back period. Taxpayer utilized a Qualified Intermediary to receive
the funds from the sale and acquire replacement property from an unrelated
party. The third letter ruling involved a Taxpayer who engaged in a reverse
exchange utilizing a Qualified Intermediary that acquired replacement property
from an unrelated party and then sold the relinquished property to a
related-party for cash. In both cases, the result was that the Taxpayer owned
replacement property with the relinquished property’s carry-over basis and the
related party owned the relinquished property with a basis equal to its fair
In both the second and third cases, the IRS held that the provisions of Section
1031(f)(1) were not applicable, even though the relinquished properties were
sold to related-parties. The IRS reasoned in each case that the Taxpayer did not
exchange property with the related-party. Instead, both taxpayers had exchanged
property with a Qualified Intermediary. Additionally, in both cases the IRS
refused to apply the anti-abuse provisions of Section 1031(f)(4) as an indirect
exchange because the related-party did not own property prior to the exchange,
and therefore, there was no impermissible basis-shifting or cashing out. (LTR.
RUL. 200709036, LTR. RUL. 200712013)
These private letter rulings confirm the widely-held opinion that a Qualified
Intermediary will be viewed by the IRS as an unrelated party under Section
1031(f)(1) for purposes of determining whether or not a taxpayer has entered
into an exchange with a related-person. Additionally, they also hold that
related-party exchanges that do not involve impermissible basis-shifting or
cashing out will not run afoul of the anti-abuse provisions of Section
Tax professionals and attorneys, therefore, can be confident that their clients’
Section 1031 transactions with related parties under Section 1031(f)(1) will
likely qualify for non-recognition of gain or loss provided that a Qualified
Intermediary is utilized in exchange transactions among related parties and as
long as these transactions do not violate the anti-abuse provisions of Section
1031(f)(4). These rulings provide excellent guidance in helping to structure
related-party transactions where an exchange is contemplated.