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Gary Gorman
Manager, Professional Exchange Accommodators
LLC, Englewood
A
recent Internal Revenue Service
ruling will now reduce taxpayer flexibility
when they complete a 1031 exchange by buying
property.
To
be clear, there are two types of exchange involving
relatives. In the simultaneous type,
you trade deeds. Section 1031 allows you to
swap properties tax-free with a relative provided
both of you then hold the property your receive
for at least two years. In the deferred
type of exchange, you sell your property
to a third party and use the money to buy your
relative's property section 1031 (f) prohibits
such a purchase unless you can prove to the
IRS that you had no motive to avoid tax. The
new ruling pertains to this deferred type involving
a relative.
Prior to this ruling, many exchange professionals
assumed that the "no tax avoidance"
exception meant that if a related seller of
the replacement (let's call it the "new")
property pays tax, or is able to sell the
property without tax, then you could buy from
them if they are related. For example, if
your brother is selling you a house that he
owns, and would have no tax liability because
he is selling it at a loss, it was felt that
your purchase of the property would be allowed
because their is no tax avoidance. This is
also true if it was his personal residence
and the gain is excluded or if your brother
merely declares the gain and pays the tax.
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| Professional Services |
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IRS tightens related |
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party rules |
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| As
appeared in... |
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September
2-15, 1998 |
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The
new ruling makes it clear that the IRS sees the
purchase of the new property from a related party
in a deferred exchange as a violation of the prohibition
against deferred related party dealings.
In
the Technical Advice Memorandum issued
as Private Revenue Ruling 9748006, a son sold
an undivided interest in bare land and immediately
purchased a residence from his mother. The mother
hand purchased the residence just prior to it
acquisition by the son and had no taxable gain
on the sale. The son used a number of arguments
making his case that the exchange should stand,
the most prominent of which was that there was
no tax avoidance in the transaction because the
mother had no gain. The IRS disagreed and ruled
that the purchase violated Section 1031(f) because
the family unit (e.g., the mother and son) ended
up with both the house and the cash in completion
of the exchange.
One of the son's other arguments was that because
he had use a qualified intermediary to handle
his exchange, he had purchase the new property
from the qualified intermediary, who was not related,
rather than from his mother. Since the acquisition
of the house from the mother happened simultaneously
with the sale of the land, it seems that the only
use of the qualified intermediary was to insert
an unrelated party between the son and the mother.
The IRS stated that the use of a qualified intermediary
would not correct an otherwise flawed transaction.
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This
is the first ruling the IRS has issued concerning
deferred related part replacements in a 1031 exchange.
It makes it clear that the IRS intends to narrowly
apply the tax avoidance exemption allowed by 1031(f)
in all cases except a direct swap of property.
And it imposes a new rule of thumb that might
simply be stated as follows:
"If
the buyer and the seller are related, and one
of the parties ends up with the property and the
other ends up with the cash, the exchange will
be disallowed."
As with many IRS ruling, it raises more questions
than it answers. Most obvious is the question
of "what situation would give rise to a ‘no
tax avoidance' situation." Nor is the ruling
clear about what the son intended to do with property.
The implication is that the son indented to rent
the property to the mother. The IRS did not address
that issue. And most interesting was the fact
that this transaction was in effect a reverse
exchange since the new property was acquired for
the taxpayer before the taxpayer had closed the
sale of the old property. |
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