Related Party Alternative to a Reverse Exchange

Can a taxpayer set up an exchange, sell his relinquished property to a related party to hold for resale and complete his exchange by taking title to his replacement property? This scenario would make it unnecessary for an Exchange Accommodation Titleholder (“EAT”) to take temporary title to the replacement property and hold it while the taxpayer is searching for a buyer for his relinquished property.

In the usual Reverse Exchange, the taxpayer engages an EAT (usually a subsidiary of the QI) to take temporary title to a property. The property will subsequently be deeded to the taxpayer as replacement property in a § 1031 exchange. This is usually done because the taxpayer has to close on the purchase of a replacement property before the sale of a relinquished property. Under the “safe-harbor” provisions of Revenue Procedure 2000-37 the EAT can hold the property for no longer than 180 days. During this time, the taxpayer must find a buyer for his relinquished property, close on the sale and complete his 1031 exchange by taking title to the parked replacement property.

An alternative which is attracting interest lately is for the taxpayer to sell his relinquished property to a related party (corporation, LLC or partnership which is owned by him and/or related family members)> The taxpayer then takes title to the replacement property and complete the exchange immediately. The related party can then hold the relinquished property while listing for sale to an unrelated third party with no exchange time limitations or holding requirements.

When property is exchanged between related parties, each related party is compelled by the Regulations to hold the property it received for two years. A disposition by either related party would disqualify the exchange and each related party would be required to amend their returns and report the exchange as a taxable sale. A sale to a related party and replacement from an unrelated party has been thought to be subject to this rule as well. It has been the thinking that a related party had to hold the property for at least two years before the property could be resold. However, three private letter rulings issued by the IRS in 2007 say this is not so and that the two-year holding period does not apply (PLRs 200706001, 200712013 and 200728008).

The related party can acquire the relinquished property from the taxpayer at the same time that the taxpayer is taking title to the replacement property. Subsequently, the related party can hold the property for sale to a third party with no 180 day time limit and not be subject to the two-year holding period. The related party has a tax basis equal to the purchase price. So, when the property is resold, there should be little or no taxable gain on the sale. The taxpayer’s exchange is completed and everyone is happy.

A variation on this theme is for the taxpayer to engage the services of an EAT to initially take title to the replacement property. The EAT holds the property for up to 180 days hoping that a buyer can be found for the relinquished property in time to complete the exchange. If a buyer is not found, the taxpayer then sells the relinquished property to a related party and takes title to the replacement property from the EAT. His exchange is complete and is under the protection of the safe harbor provisions of Rev. Proc. 2000-37. This arrangement may be more compatible with the taxpayer's circumstances at the time of the replacement property closing.