Several private letter rulings have confirmed the parameters for an interesting tax planning opportunity involving related parties engaged in a like kind exchange. The technique allows a taxpayer who wants to dispose of a property to purchase the replacement property from a related party, which may be helpful in situations where the taxpayer has trouble finding acceptable replacement property within the time frames required by I.R.C. § 1031. In addition, the technique essentially allows basis to be shifted from one property to another property among related parties. This may be useful where a taxpayer wishes to dispose of a low-basis property. By exchanging that property with a high-basis property owned by a related party, the related group can ultimately sell the property they wish to dispose of, but that property will carry the high-basis upon its disposition.
Related party exchanges are generally governed by I.R.C. § 1031(f), which provides that if a taxpayer engages in an exchange which otherwise qualifies under § 1031 with a related party, gain will have to be recognized if either the taxpayer or the related party disposes of the property received in the exchange within two years of the exchange. The concern in many of these transactions is I.R.C. § 1031(f)(4), which states that I.R.C. § 1031 will not apply to any transaction or series of transactions structured to avoid the purpose of § 1031(f). However, the two-year period in § 1031(f) is essentially treated like a safe harbor.
In our view, the purpose of section 1031(f)(4) is to stop taxpayers from violating the two-year rule, and not to preclude taxpayers from planning to dispose of property after the two-year period. Thus, if a taxpayer exchanges property with a related party, intending to dispose of the replacement property after the two-year period, section 1031(f)(4) would not require recognition of the original gain. This analysis would not apply, however, if the exchange were a sham.
Using related parties in like kind exchanges can be helpful in locating acceptable replacement property and shifting basis from a high-basis property to a low-basis property. However, taxpayers must structure their exchange to either wait two years to cash out their investment, or sell the desired relinquished property in another qualified exchange.
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