Section 1031(f)

That structure makes section 1031(f) unlike anything else in this Part. The exchange qualifies when it is done. A later event reaches back and disqualifies it, and the tax falls in the later year. A practitioner who advises on a related party exchange and closes the file has not finished the engagement.

40.1 Direct exchanges between related persons

The operative rule has three predicates and one consequence.¹

Where a taxpayer exchanges property with a related person, where there is nonrecognition to the taxpayer under section 1031 determined without regard to subsection (f), and where before the date two years after the date of the last transfer which was part of the exchange either the related person disposes of the property received from the taxpayer or the taxpayer disposes of the like-kind property received from the related person, there is no nonrecognition of gain or loss to the taxpayer with respect to the exchange.

The consequence has a timing rule attached that is easy to miss and important. Any gain or loss recognized by reason of subsection (f) is taken into account as of the date on which the disposition occurs.²

Three features of that architecture govern the rest of this chapter.

The condition is bilateral. Either disposition triggers it. The taxpayer who intends to hold indefinitely is still exposed to a sale by the related person, and the taxpayer will usually not learn of it until a return is prepared.

Each party is analyzed separately. The statute denies nonrecognition "to the taxpayer" with respect to the taxpayer's exchange. In a two party swap, each participant is a taxpayer with a related person, and each runs the analysis on its own facts.

The recognition is prospective in timing and retroactive in effect. No amended return is filed. The deferred gain is reported in the year of the disqualifying disposition.

The purpose the provision serves is stated by the Service in the ruling examined in Chapter 41. Section 1031(f) is intended to deny nonrecognition for transactions in which related parties make like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property.³ The legislative history puts it in economic terms: if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, cashed out of the investment, and the original exchange should not be accorded nonrecognition treatment.⁴

That sentence is the key to the entire Part. The question the statute and the cases keep asking is whether cash left the related group.

40.2 The definition of related person

For purposes of subsection (f), a related person means any person bearing a relationship to the taxpayer described in section 267(b) or section 707(b)(1).⁵

Note what is absent. There is no substitution of ten percent for fifty percent. The disqualified person rules of Chapter 28 import the same two provisions with that substitution, which makes them far broader.⁶ A person may be a disqualified person who cannot serve as intermediary and yet not be a related person for purposes of this chapter, and the reverse is also possible. The two regimes are frequently conflated and should not be.

The family definition is narrow. The family of an individual includes only brothers and sisters, whether by the whole or half blood, a spouse, ancestors, and lineal descendants.⁷ A taxpayer's sibling, parent, grandparent, child, and grandchild are related persons. A taxpayer's in-laws, aunts and uncles, nieces and nephews, and cousins are not.

The entity tests use the fifty percent threshold. An individual and a corporation more than fifty percent in value of the outstanding stock of which is owned directly or indirectly by that individual are related, as are a partnership and a person owning directly or indirectly more than fifty percent of its capital or profits interest, and two partnerships in which the same persons own more than fifty percent.⁸ The constructive ownership rules apply, and a structure that looks unrelated on its face may not be once attribution is run.

The Service's own summary for taxpayers is a serviceable first screen: a related party includes a spouse, child, grandchild, parent, grandparent, brother, sister, or a related corporation, S corporation, partnership, trust, estate, or tax exempt organization.⁹

Indirect exchanges count. The Service treats an exchange made through an intermediary with a related party, and an exchange made by a disregarded entity such as a single member limited liability company where the taxpayer or a related party owned that entity, as exchanges made with a related party.¹⁰ The disregarded entity point follows from Chapter 19: the entity is not the taxpayer, its owner is.

40.3 The two-year holding requirement

The period runs until the date two years after the date of the last transfer which was part of such exchange.¹¹

That measurement date deserves emphasis because it is the opposite of the rule governing the identification and exchange periods. Those run from the earliest transfer where multiple properties are relinquished.¹² The related party period runs from the last transfer. A practitioner who computes both from the same date has one of them wrong.

The period can be suspended. Where the holder's risk of loss with respect to the property is substantially diminished, the running of the two year period is suspended for the duration.¹³ The statute identifies three ways that happens: the holding of a put with respect to the property, the holding by another person of a right to acquire the property, or a short sale or any other transaction.¹⁴

Two of those matter in real property practice. An option granted to a prospective buyer is a right to acquire held by another person, and it tolls the clock for as long as it is outstanding. A right of first refusal, depending on its terms, may present the same question. The catch-all reaching any other transaction is broad enough that any arrangement transferring the economics of ownership while leaving title in place should be analyzed before it is documented.

The practical consequence is that a related party who grants an option in month twenty is not two years clear in month twenty five. The clock stopped.

There is an affirmative annual reporting obligation, and it is routinely missed. Part II of the return form must be completed for each of the two years following the year of the exchange, answering whether the related party or the taxpayer disposed of any part of the like-kind property during that year and before the two year date. Where both answers are no and it is not the year of the exchange, the taxpayer stops there.¹⁵

A form filed in years two and three with two boxes checked "No" is not a formality. It is the taxpayer's own record that the condition was satisfied, and its absence is the first thing an examiner will notice.

40.4 Dispositions that trigger retroactive recognition

The statute speaks of the related person or the taxpayer disposing of the property and does not define disposition. A sale plainly qualifies. Beyond that the term should be read broadly and every transfer analyzed, because the exceptions in 40.5 exist precisely to carve out transfers that would otherwise be caught.

The timing rule is the taxpayer's only comfort. Gain or loss recognized by reason of subsection (f) is taken into account as of the date the disposition occurs.¹⁶ There is no amended return, no interest running from the year of the exchange, and no penalty for a return that was correct when filed. The deferred gain from the exchange computation is simply reported in the year the condition fails.¹⁷

One consequence runs in the taxpayer's favor and is rarely mentioned. The statute denies nonrecognition of gain or loss. Where the exchange would have produced a realized loss that section 1031(c) disallowed, a disqualifying disposition removes section 1031 from the transaction, and the loss is no longer disallowed by that provision. Whether the loss is then allowable is a separate question, because section 267(a)(1) disallows losses on sales or exchanges between the same categories of related persons, and that provision operates on its own terms. The point is that the analysis does not end with section 1031, and a taxpayer holding a loss property should not assume that the related party rules are uniformly adverse.

The practical exposure is that the trigger is in someone else's hands. A taxpayer who exchanged with a sibling in year one has a deferral that the sibling can destroy in year two by selling, for reasons that have nothing to do with the taxpayer. Three measures address that, and all three are cheap.

Obtain a written acknowledgment from both parties, at closing, of the two year obligation and of the consequence of breaching it.

Consider a contractual restriction on transfer for the two year period, with the caution that a restriction giving another person a right to acquire the property will toll the period under 40.3 rather than protect it.

Calendar the date and the two intervening return filings, and tell the client's accountant. The obligation outlives the engagement and the exchange file.

40.5 The statutory exceptions

Three dispositions are not taken into account, and a taxpayer whose two year period has been broken should work through all three before conceding.¹⁸

Death. A disposition after the earlier of the death of the taxpayer or the death of the related person is disregarded. The exception is unconditional and requires no showing of purpose.

Involuntary conversion. A disposition in a compulsory or involuntary conversion within the meaning of section 1033 is disregarded, but only if the exchange occurred before the threat or imminence of the conversion. A taxpayer who exchanged into property already under threat of condemnation does not qualify.

No principal purpose of tax avoidance. A disposition with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor the disposition had as one of its principal purposes the avoidance of federal income tax is disregarded.

That third exception is the one most often invoked and the one most often misdescribed. Read its terms.

The test is one of its principal purposes, not the principal purpose. A transaction may have a genuine and dominant business reason and still fail, if tax avoidance was also a principal purpose.

Both the exchange and the disposition must clear the test. Establishing that the later sale was innocent does not help if the exchange itself was structured for tax avoidance.

The burden is on the taxpayer, and it is a burden of establishing the point to the satisfaction of the Secretary. The exception is claimed by checking a box on the return and attaching an explanation.¹⁹

The Service has identified three situations in which tax avoidance generally will not be seen as a principal purpose, and they are the closest thing to guidance available: a disposition of property in a nonrecognition transaction; an exchange in which the related parties derive no tax advantage from the shifting of basis between the exchanged properties; and an exchange of undivided interests in different properties that results in each related party holding either the entire interest in a single property or a larger undivided interest in any of the properties.²⁰

The second of those states the analytical core of the whole regime and is developed at 41.2. The third is genuinely useful and underused: related co-owners unwinding fractional interests into whole parcels are performing exactly the transaction the Service has said it does not regard as abusive.

A fourth provision is not an exception but an expansion, and it is the subject of Chapter 41. Section 1031 does not apply to any exchange which is part of a transaction, or series of transactions, structured to avoid the purposes of subsection (f).²¹ That sentence is what prevents a taxpayer from stepping around this chapter by inserting an unrelated intermediary, and the courts have applied it without a single contrary decision.