1031 Exchanges –Navigating Related Party Exchanges
December 22, 2021
At a glance:
- The main takeaway: With careful tax planning, 1031 exchanges offer taxpayers an opportunity for big savings on income taxes.
- Know the risks: Few good things ever come easy, and 1031 exchanges are no different. One of the biggest risks is structuring a transaction with a related party.
- Next Steps: Taxpayers can often mitigate the risks of a 1031 exchange through strategic planning and the help of an expert tax advisor.
The full story:
Savvy investors know that good, old-fashioned tax planning can be just as critical as landing that perfect property when it comes to successful real estate investments. There are so many programs and incentives available to help taxpayers maximize their investment, but the rules and risks can get complicated fast. IRS Section 1031 on like-kind exchanges, simply termed a 1031 exchange in practice, is the perfect example of this.
Breaking down section 1031
Section 1031 allows property owners to swap one property for another to defer capital gains taxes. When used correctly alongside sophisticated tax planning, a 1031 exchange can yield excellent tax results. It might be easier to understand the mechanics of a 1031 exchange through an example. Let me introduce you to Davis and Lisa:
David bought a warehouse for $6 million that is now worth $10 million. He wants to get rid of the property, but selling it at value would mean John must pay capital gains taxes on the $4 million profit.
Lisa owns two buildings collectively valued at $10 million, which she purchased for $10 million. She is not currently planning on selling her investment properties.
In this scenario, a 1031 exchange could help David get rid of his warehouse property without facing the substantial capital gains taxes by trading with Lisa. Because David’s warehouse and Lisa’s properties have equivalent value, trading properties would mean David essentially “paid” for the two properties with his warehouse valued at $10 million, which allows him to turn around and sell the buildings without reporting a profit. Meanwhile, Lisa still has a $10 million investment property that she can hold on to.
This is an oversimplification, of course, but it illustrates the core purpose of a 1031 exchange: with careful planning and advisement, David can defer a very large tax burden.
Understand the risks
A 1031 exchange boasts potentially massive savings, but it also carries some complex exceptions and restrictions, meaning you’ll only benefit as long as each party avoids the risks.One of the biggest risks associated with a 1031 exchange is the significantly stricter rules for exchanging properties among related parties.
Let’s revisit the previous example. I left out one piece of critical information: David and Lisa are siblings. According to the IRS, this makes them related parties – and potentially disallows the 1031 exchange. Other related parties, as defined by the tax code, include any immediate family members and any companies with 50% or more ownership by the taxpayer.
While the IRS doesn’t automatically disallow all 1031 exchanges between related parties, the tax code sets forth very clear restrictions that make it much more difficult for related parties to benefit:
- The taxpayer must prove that the transaction was not structured to intentionally avoid taxation. This is a tough hurdle to overcome, as the IRS will assume tax avoidance took place if the 1031 exchange yielded a substantially better economic benefit than a direct sale.
- A 1031 exchange between related parties, if allowed, requires a longer holding period. A taxpayer that acquires property from a related party through a 1031 exchange must hold the property for a minimum of 2 years to defer the tax.
The bottom line
A 1031 exchange can be an invaluable tool for property owners looking to manage investments more creatively. The potential tax benefits are expansive – but only when executed through a carefully coordinated tax strategy. Simply trading properties with the wrong person could negate all of the 1031 advantages.
If you think a 1031 exchange might be right for you or your company, discuss the transaction with a tax advisor first. Aprio’s real estate tax experts have helped defer more than $5 million in income tax through strategically planned 1031 like-kind exchanges. Contact us today for a consultation.
About the Author
Sandi is a partner in the Tax practice at Aprio, LLP. She has more than 10 years of experience providing tax services in a variety of industries, with a primary focus on the real estate industry. Sandi regularly helps real estate developers, property managers, homebuilders, real estate funds and real estate investment trusts address complex tax issues and minimize their tax liabilities.