Rulings Relax Related-Party Exchange Rules

By Gabriel Cohen, CPA; Stephanie Tran, J.D., LL.M.

Editor: Annette B. Smith, CPA

Recently released IRS Letter Rulings 200709036 and 200706001 suggest a liberal trend regarding related-party exchanges under Sec. 1031(f). The rulings may indicate a more favorable Service attitude toward exchanges in which the related parties have not cashed out of their original investments through “abusive” basis-shifting.


Sec. 1031(a) allows a taxpayer to defer gain or loss recognition if property held for productive use in a trade or business or investment is exchanged solely for property of like-kind also held for a qualified use. In a deferred like-kind exchange, a taxpayer is bound by certain time limits in which to complete an exchange, including the requirement that the replacement property generally must be received within 180 days of the disposition of the relinquished property or, in the case of a reverse exchange, the “parked” property must be transferred to the taxpayer as replacement property within 180 days after the accommodation party acquires title of the parked property; see Sec. 1031(a)(3) and Rev. Proc. 2000-37. 

Related parties: Sec. 1031(f) limits exchanges of property between related parties. Enacted by Congress in 1989, it is intended to prevent abusive scenarios in which a taxpayer uses a like-kind exchange to swap high-tax-basis property for low-tax-basis property with related parties in anticipation of selling the low-basis property; the taxpayer would effectively “cash out” of the original investment in the low-basis property, by selling it shortly after the exchange, with little or no gain recognition.

In general, Sec. 1031(f)(1) provides that a taxpayer exchanging like-kind property with a related person may not use Sec. 1031 if, within two years of the date of the last transfer, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. In addition, pursuant to the anti-abuse rule of Sec. 1031(f)(4), if an unrelated third party is used to circumvent the purposes of the related-party rule in Sec. 1031(f), the nonrecognition treatment under Sec. 1031(a) does not apply to the transaction. However, in situations that do not involve abusive basis-shifting, Sec. 1031(f)(2)(C) provides a nontax-avoidance exception to the related-party rules. 

In recent years, both the IRS and the Tax Court have invoked the Sec. 1031(f)(4) anti-abuse rule to disallow an indirect exchange between related parties, in which a third-party qualified intermediary (QI) is used, in a series of steps, to avoid a direct exchange between related parties that would result in gain recognition under Sec. 1031(f)(1). In Rev. Rul. 2002-83, the Service applied Sec. 1031(f)(4) to disallow a deferred exchange when a taxpayer transferred relinquished property to a QI in exchange for replacement property owned by a related party, and as part of the transaction, the related party received cash for the replacement property. Similarly, in Teruya Brothers, 124 TC 45 (2005), the Tax Court applied Sec. 1031(f)(4) to recharacterize an indirect exchange through a QI between related parties as a direct property exchange between them, followed by a disposition of the relinquished property. Thus, both Rev. Rul. 2002-83 and Teruya Brothers represented transactions that, though not direct related-party exchanges as described in Sec. 1031(f)(1), nonetheless did not qualify for nonrecognition treatment due to Sec. 1031(f)(4).

Letter Ruling 200709036

In the ruling, Taxpayer, a limited liability company (LLC) taxed as a partnership, owned an office and retail property through another LLC that was a disregarded entity for income tax purposes. Taxpayer was indirectly owned by a public real estate investment trust (REIT) through its operating partnership (OP). The REIT, through its OP, also owned a taxable REIT subsidiary (TRS) that was to buy the relinquished property from Taxpayer. Thus, TRS and Taxpayer were considered related parties through common ownership by the OP and the REIT.

Taxpayer transferred its LLC interest in the office/retail property (relinquished property) to the TRS through the QI for fair market value (FMV). QI then used the cash proceeds from the related-party TRS to purchase like-kind replacement property from an unrelated seller and transferred the replacement property to Taxpayer to complete the exchange within the prescribed 180 days. It was anticipated that the TRS would dispose of some or all of Taxpayer’s relinquished property within two years of acquisition.

Because the disposition occurred between Taxpayer and the QI (rather than directly between Taxpayer and the TRS), the Service held that the transaction was not within Sec. 1031(f)(1)’s proscription. In analyzing the transaction, the IRS discussed Rev. Rul. 2002-83 and the legislative history behind Sec. 1031(f)(4), but noted favorably that the TRS, a related party, acquired the relinquished property for an FMV price from the QI. Consequently, the Service held that there was no basis-shifting and that Sec. 1031(f)(4) did not apply. (A similar ruling involving a reverse exchange using Rev. Proc. 2000-37 occurred in Letter Ruling 200712013.) 

Letter Ruling 200706001

In the ruling, a taxpayer and her siblings inherited three parcels of timberland (Parcels 1–3). The taxpayer exchanged her undivided 25% interest in Parcel 1 for a fee simple interest in Parcel 3 that was owned by a trust. Because the trust beneficiaries were the taxpayer’s mother (a life beneficiary) and her siblings (remainder beneficiaries), the exchange was with related parties. Following the exchange, the trust and the siblings (the related parties) sold Parcels 1 and 2 to an unrelated third party. The taxpayer represented that all the owners had the same per-acre basis in Parcels 1 and 3.

Citing Rev. Rul. 73-476 (holding that an exchange of an undivided interest in real estate for a fee interest in real estate was an exchange of like-kind properties), the IRS held that the exchange of a 25% undivided interest in Parcel 1 was of like-kind to the fee interest in Parcel 3. In addition, it held that the subsequent sale by the trust (the related party) of its interest in Parcel 1 was not a disposition that caused gain recognition under Sec. 1031(f), due to the application of the nontax-avoidance exception of Sec. 1031(f)(2)(C). This conclusion was based primarily on the taxpayer’s representation that the owners had the same per-acre basis in the relevant properties; thus, there was no basis-shifting. 


These letter rulings represent instances in which the Service did not invalidate exchanges that involved related parties, either directly or indirectly through the use of the QI, if there was adequate showing of no abusive basis-shifting in properties between related parties. As a result, taxpayers may have additional flexibility to structure related-party exchanges in appropriate circumstances.


Annette B. Smith, CPA, Washington National Tax Services PricewaterhouseCoopers LLP, Washington, DC.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers, LLP.

If you would like additional information about these items, contact Ms. Smith at (202) 414–1048 or

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