Intermediated Related-Party Exchanges

If the taxpayer transfers relinquished property to a qualified intermediary and receives replacement property from the intermediary, the exchange is nominally with the intermediary, and the intermediary is unrelated.

That structure has been tested in a published ruling and in three courts of appeals over a period of thirteen years. It has failed every time. This chapter sets out why, and identifies the narrow circumstances in which acquiring replacement property from a related person still works.

41.1 Acquiring replacement property from a related person

The Service addressed the structure directly in a revenue ruling whose facts are worth stating in full, because every later case is a variation on them.¹

Individual A owns Property 1, worth $150x with an adjusted basis of $50x. Individual B owns Property 2, worth $150x with an adjusted basis of $150x. Both are held for investment, and A and B are related persons within the meaning of section 267(b). C, unrelated to either, wants to acquire Property 1.

A enters into an agreement with B, C, and a qualified intermediary that is unrelated to A and B. A transfers Property 1 to the intermediary, which transfers it to C for $150x. The intermediary then acquires Property 2 from B, pays B the $150x of sale proceeds, and transfers Property 2 to A.

The Service's analysis proceeds by comparison. Absent section 1031(f)(1), A could have exchanged Property 1 for Property 2 with B directly, and B could then have sold Property 1 to C. That transaction is squarely within section 1031(f)(1), because A and B are related and B disposed of the property within two years, so nonrecognition would be denied.

To avoid that result, A instead transferred the low basis property to the intermediary, which sold it to C for cash, acquired the high basis replacement property from B, and paid B the cash. A thereby exchanged with an unrelated third party rather than with B. But the end result is the same as if A had exchanged with B and B had sold to C, and the series of transactions allows A to cash out of the investment in Property 1 without recognizing gain.²

The holding. A taxpayer who transfers relinquished property to a qualified intermediary in exchange for replacement property formerly owned by a related party is not entitled to nonrecognition treatment under section 1031(a) if, as part of the transaction, the related party receives cash or other non-like-kind property for the replacement property.³

The exchange is treated as a taxable transaction, and A recognizes $100x under section 1001(a), being the difference between the $150x fair market value of Property 2 and A's $50x basis in Property 1.⁴

The statutory hook is section 1031(f)(4), which provides that section 1031 does not apply to any exchange that is part of a transaction, or series of transactions, structured to avoid the purposes of subsection (f). Its legislative history anticipated the structure in almost these terms: if a taxpayer, pursuant to a pre-arranged plan, transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within two years of the previous transfer in a transaction otherwise qualifying under section 1031, the related party will not be entitled to nonrecognition treatment.⁵

The Service states its position on the return form itself, which is worth knowing because it changes what a preparer should file. The instruction directs the taxpayer not to file Form 8824 where a related party sold property into the exchange, directly or indirectly such as through an intermediary, that property became the taxpayer's replacement property, and none of the statutory exceptions applies. The taxpayer instead reports the disposition of the property given up as if the exchange had been a sale.⁶

Filing a Form 8824 in that circumstance is an affirmative claim of a position the Service has announced in advance that it rejects.

41.2 The basis-shifting concern

Understanding why the structure fails requires working the arithmetic of the abuse it replicates, because the objection is not that a related party was involved. It is that basis moved.

Return to the ruling's numbers and run the direct exchange that section 1031(f)(1) would have caught.

A holds Property 1 with a $50x basis and $100x of built-in gain. B holds Property 2 with a $150x basis and no built-in gain. They exchange. Under section 1031(d), A takes a $50x basis in Property 2, and B takes a $150x basis in Property 1. The built-in gain has not disappeared; it now sits with A, who intends to hold.

B then sells Property 1 to C for $150x. Because B's basis in Property 1 is $150x, B recognizes nothing.

The related group has converted Property 1 into $150x of cash and reported no gain in the year of the transaction. The $100x of gain still exists, embedded in A's low basis in Property 2, but the family has the money now and the tax later, possibly much later, and possibly never if A holds until death.

That is the transaction section 1031(f)(1) denies, and the Service's statement of purpose describes it precisely: the provision 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.⁷

The intermediated version reaches the identical economics. The intermediary sells A's low basis property to C for cash, delivers the cash to B, and delivers B's high basis property to A. B has sold Property 2 for its basis and recognizes nothing. A holds Property 2 with a $50x carryover basis. C has Property 1. The related group has $150x of cash and reported no gain. Only the sequence differs.

The analytical test that emerges is therefore not whether an intermediary was used, and not whether the taxpayer had a business reason. It is whether the related group ended up in a materially better tax position than it would have occupied had the parties exchanged directly. Where the answer is yes, section 1031(f)(4) applies.

The Service's own guidance on the statutory exception states the same idea from the other side, identifying as a situation in which tax avoidance generally will not be seen as a principal purpose an exchange in which the related parties derive no tax advantage from the shifting of basis between the exchanged properties.⁸

No basis shift, no problem. A basis shift plus cash out of the group, and the exchange fails.

41.3 The non-tax-avoidance exception and its burden

The exception of section 1031(f)(2)(C) remains available, and a taxpayer with genuine facts should not be talked out of it. Its terms are demanding and should be read to the client before the transaction rather than after.

It must be 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.⁹

Three features of that formulation define the exposure.

The standard is not a dominant purpose test. Tax avoidance need only be one of the principal purposes. A transaction driven overwhelmingly by business considerations fails if tax avoidance was also a principal objective, and a contemporaneous file describing the tax benefit as a reason for the structure supplies the government's proof.

Both legs must clear it. An innocent later disposition does not rescue an exchange that was itself structured for avoidance, and a legitimate exchange does not survive a disposition undertaken to harvest the shifted basis.

The burden is affirmative and procedural. The exception is claimed by checking a box on the return and attaching an explanation.¹⁰ An explanation drafted in the year of examination, from reconstructed facts, is worth a fraction of one written when the decision was made.

The Service's three published situations are the practical guide, and the second and third do real work.¹¹

A disposition of property in a nonrecognition transaction is generally not a tax avoidance disposition. A related party who disposes of the property in a transaction that itself defers gain has not cashed out.

An exchange in which the related parties derive no tax advantage from the shifting of basis is generally not abusive. This is the test of 41.2 stated as guidance, and it is the ground on which a well documented related party exchange should be defended.

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 is generally not abusive. This is a genuinely useful and underused statement, because it describes the ordinary partition among related co-owners. Family members unwinding fractional interests across several parcels into whole parcels are performing the transaction the Service has identified as unobjectionable.

41.4 Judicial application across the circuits

Three courts of appeals have applied section 1031(f)(4) to intermediated related party exchanges. All three ruled for the government, and there is no contrary appellate authority.

The Ninth Circuit denied nonrecognition where the taxpayer disposed of relinquished property through a qualified intermediary and acquired replacement property from a related entity that received cash, holding the transaction within section 1031(f)(4).¹² The Supreme Court denied review.¹³

The Eleventh Circuit reached the same result, affirming the Tax Court, where a taxpayer sold a shopping center through an intermediary and acquired the replacement property from a limited liability company owned by the same shareholders.¹⁴

The Eighth Circuit supplied the most useful formulation, on facts that make the underlying objection unusually clear.¹⁵ An equipment leasing company sold used equipment through a qualified intermediary and acquired replacement equipment from a related dealer. The taxpayer could have acquired the replacement equipment directly from the manufacturer through the intermediary. It did not, because the related dealer could purchase from the manufacturer under an interest free payment program, receive the exchange funds from the intermediary immediately, and hold those funds for months before paying the manufacturer.

The court affirmed judgment for the United States, reasoning that a transaction may be treated as structured to avoid the purposes of section 1031(f) where, at least in part, the parties could have completed the transactions without the involvement of the related party. The related dealer was unnecessary to the exchange and was present to obtain a financial benefit.

Two observations about that line of authority.

The Eighth Circuit case involved equipment, which after 2017 is outside section 1031 entirely. The fact pattern is not repeatable, but the reasoning is unaffected, and its question is the right one to ask of a real property structure: could this transaction have been completed without the related party, and if so, what was the related party there for.

The absence of a circuit split matters practically. A taxpayer contemplating an intermediated acquisition from a related person is not choosing between competing authorities. The taxpayer is choosing whether to litigate against a published ruling, an administrative instruction on the return form, and three unanimous appellate decisions.

41.5 Where the related party also cashes out

The organizing question, drawn from the legislative history and confirmed by every authority in this chapter, is whether cash left the related group.¹⁶

Structure one: the related party sells into the exchange and receives cash. This is the ruling's fact pattern and the fact pattern of all three appellate decisions. The related party has converted an appreciated or high basis asset into money, the taxpayer holds replacement property with a shifted basis, and the group reported nothing. Section 1031(f)(4) applies and the exchange is a sale.

Structure two: the related party completes a qualifying exchange of its own. The related party transfers its property into the transaction and receives like-kind replacement property rather than cash, and both parties hold for the two years required by 40.3. No one cashed out. The related parties derive no tax advantage from the basis shift because no gain has been converted into money, and the exception of 41.3 is at its strongest.

The distinction is economic rather than formal, and the presence or absence of an intermediary is irrelevant to it. That is the point the taxpayers in the three appellate cases did not accept.

Counsel where a client proposes to acquire from a related person.

Identify the relationship first, using the fifty percent tests of 40.2 with attribution, and record the conclusion. Practitioners who screen only for disqualified persons under Chapter 28 are applying a different and broader test to a different question.

Where the related person will receive cash, advise that the transaction be planned as taxable. That advice is unwelcome and it is correct. The alternative is a position the Service has instructed preparers not to report on the exchange form at all.

Where the related person will also exchange, document both sides. The two year obligation runs on both properties, the tolling rule of section 1031(g) applies to both, and the annual reporting of 40.3 is required of the taxpayer regardless of what the related person does.

Where the exception of section 1031(f)(2)(C) is relied on, write the explanation before the closing. The statute requires the taxpayer to establish the absence of a tax avoidance purpose, and the only evidence that carries weight is contemporaneous.

Finally, treat section 1031(f)(4) as a doctrine rather than a rule. Its text reaches any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the subsection,¹⁷ which is a standard rather than a test, and it operates alongside the judicial doctrines examined in Chapter 42. A structure that satisfies every explicit requirement in this Part and exists only to reach a result the statute forbids has not solved the problem.