Sec. 1031 related-party exchanges and basis shifting.

• Author: Wong, Alan

Sec. 1031 and the underlying regulations govern the tax treatment of like-kind exchanges of property. These provisions generally permit taxpayers who satisfy the requirements of Sec. 1031 to sell property, purchase like-kind replacement property, and defer the recognition of some or all of the realized gain (subject to certain exceptions). Not surprisingly, the Code provides a number of related-party exceptions designed to circumvent certain abuses. The most prevalent of those abuses is "basis shifting," which may occur in both obvious and not so obvious circumstances. It is the "not so obvious" variety that may trip up the novice practitioner.

The fundamental construct of a Sec. 1031 basis shift can be best understood byway of an example.

Example 1: X and Y are related parties (within the meaning of Sec. 267). X owns a high-value/low-basis warehouse with a fair market value of $1,000 and an adjusted basis of $200. Y owns a high-value/ high-basis apartment building with a fair market value of $1,000 and an adjusted basis of $1,000. The related group (X and Y) wants to sell the warehouse (low-basis property) for $1,000 but wants to avoid the recognition of an $800 gain ($1,000 sale price less $200 adjusted basis). Is there a way for X and Y to trade their respective adjusted tax bases? Perhaps X and Y could simply enter into a Sec. 1031 like-kind exchange and trade properties with each other. In doing so, Y's $1,000 pre-exchange basis in the apartment would carry over to the warehouse. This would make it possible for Y to sell the warehouse (presumably to an unrelated party) without realizing or recognizing a gain ($1,000 sale price less $1,000 carryover basis). From the perspective of the related group, and in the absence of a special rule to the contrary, the group will have effectively cashed out on the sale of the warehouse on a tax-deferred basis. However, the related-party exceptions prevent this perceived abuse under most circumstances.

There are three related-party exceptions: (1) the two-year/second disposition rule (Sec. 1031(f)(1)); (2) the rule against transactions structured to avoid the purpose of Sec. 1031(f)(1) (Sec. 1031(f)(4)); and (3) the principal purpose to avoid tax rule (Sec. 1031(f)(2)(C)). For purposes of Sec. 1031, a related person is defined as a person having a relationship to the taxpayer described in the long list of relationships in Sec. 267(b) or Sec. 707(b)(1).

Two-year/second disposition: Sec. 1031(f)(1)...