News Flash: IRS Gets Tough with Related Party Rules!

Two new events are confirming the IRS's determination to put teeth in their related party rules. A recent Revenue Ruling says that you can't use your qualified intermediary as a buffer between you and the related party, and soon to be released changes to Form 8824 will make you state, in black and white, that your dealings were not with a related party.

Section 1031(f) of the Code says that you cannot sell to, or buy from, a related party unless both parties hold the properties for two years after the exchange. And the Code makes it clear that Section 1031 will not apply to protect any related party transaction that is structured in an attempt to avoid tax. A "related party" in the Code includes your parents and grandparents, your sisters and brothers, your spouse, your children and grandchildren, and business organizations of which you or your relatives are members.

Since historically there has been very little guidance from the IRS on related party exchanges, most tax professionals have relied upon the code section and decided that if there was no tax avoidance motive, then there would be no problem doing a related party exchange. For example, if an exchanger is purchasing his father's house as his replacement property, and the personal residence exemption for capital gain tax applied to the father (meaning the father would not have to pay tax on the sale), then the purchase should qualify for a 1031 exchange because there was no tax avoidance in the transaction. The IRS rejected this kind of reasoning in a 1997 ruling (generally termed "The Mommy Ruling" by the exchange community), which disallowed exchange treatment for a taxpayer who purchased replacement property from his mother. See my 1998 article "IRS Tightens Related Party Rules," available on our web site at expert1031.com/related.

Since the Mommy Ruling was issued, taxpayers have continued to try to reason around the prohibition against related party dealings. Another commonly used argument is to reason that if there was a qualified intermediary involved in the transaction, the taxpayer didn't really acquire the property from the related party, but rather from the qualified intermediary.

The IRS has now made it clear that it does not condone this reasoning, either. In fact, the IRS appears to be closing the door on any use of related parties in any exchange other than direct (or "simultaneous") two-party property swaps. In a recently released ruling (Rev. Rul. 2002-83), the IRS states the rule that we've been telling our clients since the Mommy Ruling came out: your exchange will be disallowed if, in an exchange with a related party, one of the parties ends up with the property, and the other ends up with the cash.

In a related development, the IRS appears ready, in the next month or so, to release a revised version of Form 8824. This version will make you state, in no uncertain terms, that you have not, directly or indirectly, sold property to, or purchased property from, a related party. Incorrectly answering this question will get you in a lot of hot water.

Watch for future articles that discuss both of these issues in detail.

--The Experts

TEE-Shots are Tips from the Exchange Experts that are designed to make you think about, and ask questions about, the 1031 exchange process.