Section 1031(f) deals with exchanges between related parties. The definition of a related party for purposes of §1031 is set out in Internal Revenue code sections 267(b) and 707(b) (1) and includes brothers, sisters, spouse, ancestors, lineal descendants, certain partnerships and corporations depending upon the amount of ownership by the taxpayer and related parties, and certain fiduciaries. §1031(f) does not prohibit related party exchanges but sets out special rules.

Basically, the rules provide that if either party to the exchange disposes of the property involved in the exchange within 2 years after the date of the last transfer that was part of the exchange, the non-recognition provisions of §1031 will not be applicable. Many people felt that this provision only applied to actual exchanges without the use of a Qualified Intermediary (QI). However, Revenue Ruling 2002-83 changed that thinking.

The facts in the Rev.Rul 2002-83 are as follows:

Taxpayer entered into an exchange agreement with a Qualified Intermediary. Pursuant to the exchange agreement the taxpayer transferred his property to the QI who sold it to c, an unrelated party for X$. The QI used the proceeds to purchase property from B, a related party and transferred the acquired property to the taxpayer in satisfaction of its exchange obligation. Note, that at no time did A contract with the related party B.

Part of the reasoning behind section 103l(f) was to eliminate the ability of related parties to transfer high basis property for low basis property and then have the low basis property sold without tax. Assume that the taxpayer has property worth $500,000 with a basis of $100,000 and the related party has property worth $500,000 with a basis of $400,000. Upon a section 1031 exchange between the two parties the taxpayer’s basis in the acquired property would be the same $100,000. The taxpayer intends to keep the property and all is well. However the related parties basis in his acquired property would be the same $400,000. But for §103l(f), the related party would be able to sell the acquired property and pay gain on only $100,000 where a sale by the taxpayer would result in a $400,000 gain. Section 103l(f) (4) provides that §1031 will not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this section. The IRS held that exchange of the taxpayer’s property with the QI was part of a transaction structured to avoid the purpose of 103l(f) and under section 1031(f) (4), since the related party received non like-kind property, i.e. cash, the transaction would not qualify for non-recognition under §1031.

Because of the complexities of exchanges with related parties it is extremely important that any taxpayer contemplating such a transaction obtain competent counsel before venturing into the transaction.