RELATED PARTY 1031 EXCHANGE RULES

The related party rules under Section one thousand thirty one subsection f generally add an extra layer of scrutiny when an investor exchanges property with a family member or a business entity they control. The rules exist generally to prevent related parties from using an exchange to shift basis between properties in a way that avoids tax, rather than to deferring it. This is a general educational overview. It is not tax, legal, or investment advice, and any exchange involving a related party should generally be reviewed with a tax advisor before it is structured.

The definition generally follows the related party rules found elsewhere in the tax code, and it generally includes immediate family members such as spouses, siblings, and lineal descendants, as well as entities in which the investor generally holds more than fifty percent ownership. A Las Vegas investor exchanging a rental property with a sibling, or with a limited liability company they majority own, generally falls under these rules, while an exchange with an unrelated third party buyer or seller generally does not.

When a related party exchange occurs, both the investor and the related party generally have to hold the properties received in the exchange for at least two years after the transaction, or the tax benefits of the exchange are generally retroactively disqualified. This two year clock generally starts on the date of the last transfer that was part of the exchange. If either party sells or otherwise disposes of their respective property before that two year period ends, the original exchange generally becomes taxable as of the date of the original transfer, not the date of the later disposition.

Without the two year holding requirement, related parties could generally use an exchange to swap a low basis property for a high basis property between family members or affiliated entities, effectively cashing out a stepped up basis without paying tax, then sell the high basis property shortly after with little or no reportable gain. The rule generally closes that door by forcing both sides to actually hold the exchanged property for a meaningful period, which generally makes basis shifting an ineffective strategy for these transactions.

A few circumstances are generally carved out from the two year requirement, though each generally has its own conditions.

• The death of either party during the two year holding period
• An involuntary conversion of the property, such as a condemnation
• Situations where it can generally be established that neither the exchange nor the later disposition had tax avoidance as a principal purpose

Because these exceptions are generally fact specific, a Las Vegas investor considering a related party exchange, whether transferring a Henderson rental to a family member or restructuring ownership through a majority owned entity, should generally have the transaction reviewed by a tax advisor before closing, since Nevada having no state income tax does not change the federal related party analysis. This overview is educational only and is not a substitute for that review.

A common scenario Las Vegas investors generally ask about involves a parent exchanging an investment property with an adult child, or two siblings restructuring jointly held rental property through separate exchanges. In these situations, the related party rules generally apply in full, meaning both the parent and the child, or both siblings, generally need to hold their respective properties for the full two year period following the exchange for the deferral to remain intact. A related exchange involving a majority owned entity, such as an investor exchanging property with a limited liability company they control along with a business partner, generally requires a careful look at the actual ownership percentages, since the fifty percent threshold generally determines whether the entity counts as related at all. Because the consequences of an early disposition generally apply retroactively to the original transfer date, families considering a related party exchange generally benefit from mapping out both parties' likely holding intentions before the transaction closes, rather than discovering a conflict after the two year clock has already started. This overview is educational only, and any related party exchange should generally be reviewed by a tax advisor familiar with the specific relationship and entities involved before it is structured.

Investors generally document the intended use and expected holding period for each property at the time of the exchange, since that contemporaneous record can generally help demonstrate that tax avoidance was not a principal purpose if the structure is ever reviewed later.

Because these transactions generally involve people who already have an ongoing relationship, families and business partners considering a related party exchange generally benefit from having the tax advisor communicate directly with all parties involved, rather than relying on one side to relay the requirements to the other informally.