<h2>What is Seller Financing?</h2>

<p>Simply put, seller financing is when the Seller of a property lends the funds for the purchase of the property to the Buyer, rather than the Buyer acquiring the funds through a financial institution. <a href="/blog/seller-financing-part-1031-exchange" title="Seller Financing Part of a 1031 Exchange">Read this blog</a> for a more detailed explanation of Seller Financing.</p>

<h2>Reasons for Seller Financing</h2>

<p>There are many reasons why Seller Financing may be considered in a real estate transaction. Some of the most common reasons could include:</p>

<ul>
<li>A more favorable interest rate through Seller Financing due to increasing interest rates at financial institutions</li>
<li>Both parties want a quick transaction and the financial institution’s loan process will take too long</li>
<li>Buyer wants a short-term note, for example 6 months, and the financial institution requires a longer term</li>
<li>Buyer has poor credit hindering a loan from a financial institution</li>
<li>Seller is eager to sell the property and offers Seller Financing to encourage a Buyer who might be otherwise hesitate due to high interest rates</li>
</ul>

<h2>Advantages of Seller Financing</h2>

<p>A transaction utilizing Seller Financing can be mutually beneficial to both the Buyer and the Seller of a real estate transaction. One shared benefit of Seller Financing is that the real estate transaction could be completed in a much speedier manner without third party lending.</p>

<p>Some other advantages for the Seller and Buyer include:</p>

<h3>Advantages of Seller Financing for the Seller</h3>

<ul>
<li>Lending the money to the Buyer could allow the Seller to earn more money on their funds than they would by depositing the money into a traditional savings account</li>
<li>Seller Financing allows the Seller to have more control over the entire real estate transaction. They know the financing is there so some of the question marks, issues, etc. that could arise with third party lending will not be a factor</li>
<li>Should the Buyer default on the loan, the Seller can foreclose on the loan and potential receive their property back without the need to return any previous payments</li>
</ul>

<h3>Advantages of Buyer Financing for the Buyer</h3>

<ul>
<li>The Buyer may get a lower interest rate, or other more favorable terms, with the Seller than through a financial institution</li>
<li>The loan process with the Seller could be much less complicated than the loan process through a financial institution</li>
<li>Reduced closing costs could be associated with Seller Financing • Seller Financing could allow for a more flexible or lower down payment</li>
</ul>

<h2>Example of Seller Financing</h2>

<p>Here is a basic example of how Seller Financing can be mutually beneficial financially for both the Buyer and the Seller of the real estate transaction.</p>

<p>Typical savings account interest rate - 0.5%</p>

<p>Average financial institution loan interest rate – 4%</p>

<p>Loan Amount - $500,000</p>

<p>If the Seller deposited their $500,000 in a savings account at a financial institution, he would earn $2500 in interest over a full year. However, if the Seller offered the Buyer an interest rate of 2% on a loan of $500,000, the Seller would earn $10,000 in interest over a year on the loan. Alternatively, if the Buyer got a loan from a financial institution at 4%, he would pay $20,000 in interest over a year to the financial institution, but he would only be paying $10,000 in interest should he accept Seller Financing at the discounted interest rate of 2%.</p>

<p>There are additional considerations for Seller financing as part of a 1031 exchange. <a href="/blog/seller-financing-1031-tax-deferred-exchange" title="Seller Financing in a 1031 Exchange">Learn more about them in this blog article.</a>&nbsp;</p>

<p>The <a href="https://www.realized1031.com/delaware-statutory-trust&quot; title="Realized DST Explanation">Delaware Statutory Trust (DST)</a> market has grown in popularity over the last few years. According to a report by Robert A. Stanger &amp; Co., the DST market <a href="https://thediwire.com/delaware-statutory-trust-offerings-on-pace-for-re…; title="DST record setting year">raised $1.7 billion through February 2022</a>, putting it on pace to be one of the largest years on record for DST offerings. There is no surprise that the DST market is heating up. As more and more deals become available, investors are looking for ways to defer their capital gains and benefit from the passive nature of DSTs. Although DSTs have been well received by investors as a replacement property option for 1031 exchanges, this type of investment should be more than a “plug-and-play” scenario. With the high velocity of deals and sometimes limited supply available in the market, performing the proper due diligence can help an investor ensure they aren’t exposing themselves to an unnecessary amount of risk.</p>

<p>In order to help you as an investor determine the good deals from the bad, Realized has provided a list of some of the questions you should consider before investing in a DST.</p>

<h2>What Should You Know Before Investing?</h2>

<p>Although DST offerings pass through several hands before making their way to investors, it is important to have a grasp on exactly what you’re entering into. Knowing and evaluating the details around a potential DST investment may keep you out of an unnecessarily risky offering. Here are some of the questions to ask when evaluating a DST offering:</p>

<ul>
<li><strong>Who is the Sponsor and what is their track record?</strong> Has the Sponsor had experience with this type of investment? How has the Sponsor managed investments in different points of the real estate cycle? Although the internet is helpful in researching a Sponsor’s background, every offering memorandum includes the Sponsor’s prior performance. However, past performance does not guarantee future results.<br />
&nbsp;</li>
<li><strong>Are the projected financials reasonable?</strong> Returns are projected and based off a Sponsor’s own models and assumptions as to how a particular property will perform. These projections try to predict rent growth and occupancy levels, and there is typically no context to their underwriting. Referring to market reports and appraisals is a good first step in determining whether a deal’s financial projections are reasonable.<br />
&nbsp;</li>
<li><strong>What do the fees look like?</strong> Almost every Sponsor will take certain fees such as an acquisition fee, a disposition fee, and an asset management fee. Assess the competitiveness of these fees to determine if they will detract from your return.<br />
&nbsp;</li>
<li><strong>What is the intended exit strategy?</strong> As DSTs have gained popularity in the 1031 space, Sponsors have developed new ways to exit an investment. Sponsors utilize both third-party sales and <a href="https://www.realized1031.com/glossary/721-upreit-exchange&quot; title="Realized UPREIT exit strategies">UPREIT exit</a> strategies. Assessing your long-term goals can help determine if the exit strategy aligns with your goals.</li>
</ul>

<h2>Additional Considerations</h2>

<p>In addition to reviewing details about the specific DST investment, there are other factors to evaluate before making an investment decision.</p>

<ul>
<li><strong>What are the geographic risk factors for this property’s location?</strong> It’s helpful to review the property’s surrounding metro to assess demand drivers and employment drivers as these ultimately drive long-term prospectus for a project. Additionally, investors should consider submarket trends including occupancy rates and median household income in the area.<br />
&nbsp;</li>
<li><strong>How might general market risks potentially affect performance?</strong> Another set of factors to consider are general market risks associated with real estate investments, such as the kind of appreciation an investor can expect. Additionally, how might current market debts affect the long-term prospects of the deal?</li>
</ul>

<p>There are a lot of factors you should evaluate before making an investment decision. Reviewing the DST offering, as well as researching the area where the investment is located, are large parts of the DST due diligence process. With the added uncertainty surrounding inflation and rising interest rates, consulting a professional can help you better understand the risks associated with an investment and whether a DST offering is likely to meet your long-term goals and objectives.</p>

<p>&nbsp;</p>

<p><strong>Authored by Realized®.</strong></p>

<p>Realized helps you exchange 1031-eligible investment properties for portfolios of commercial real estate that are customized to your shifting income needs, risk appetite, and investment goals across generations. By creating portfolios of fractional interests in Delaware Statutory Trusts (DSTs), Realized makes it easy to diversify investments across real estate sectors, geographies, and Sponsors.</p>

<p>Contact <a href="https://www.realized1031.com/&quot; title="Realized Website">Realized</a> to learn more about their due diligence and portfolio construction methodologies.</p>

<p>&nbsp;</p>

<p><em>This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. </em></p>

<p><em>Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.</em></p>

<p>Seller financing comes up most frequently where the seller is the taxpayer under an exchange, and the taxpayer is providing some seller financing to the buyer. However, it can also come up where the taxpayer is receiving seller financing from the seller of the replacement property.</p>

<h2>What is seller financing?</h2>

<p>Seller financing occurs when a person selling real estate is willing to let the purchaser pay the purchase price over time. This can be done for a wide variety of reasons such as the buyer cannot qualify for a conventional loan, or the economics of the deal require a lower interest rate compared to an outside lender. In this case the seller “holds the paper” requiring the taxpayer to pay the seller over time on specified terms. In general, it will also allow the seller to report the income from the periodic payments in the year in which they are received rather than all in the year of an outright sale.</p>

<h2>How does seller financing work?</h2>

<p>Seller financing can be structured in a couple of ways. One allows the buyer to receive title to the property at the time of closing and the other allows the buyer to take title upon payment of the last installment. More specifically, the first way would be documented with a promissory note from the buyer to the seller. This note would specify the interest rate, the length of time over which the loan was amortized, and the monthly payment amount. The note would typically be secured by a mortgage in favor of the seller as a lien against the property. In some jurisdictions the security interest used may be referred to as a trust deed or deed of trust.</p>

<p>The second way of documenting the transaction would entail some kind of installment contract between the parties. Again, there are regional differences regarding the name of that contract. It can be called an Installment Agreement for Deed or a Contract for Deed or Articles of Agreement for Deed. For tax and exchange purposes they are all the same. Generally, there would be some money paid down from the buyer to the seller and the balance financed over time. Sometimes it will be paid off at the time of the last fixed payment and in other instances it has a balloon payment for the final lump sum.</p>

<p>Whether the transaction is documented by a deed transfer at the time of the initial closing and secured by a note and mortgage or the deed passing upon final payment the tax treatment is the same. The buyer still owns the property either way, but subject to all payments being made. An analogy can be made to buying a new car with some dealer financing. In the case of an installment contract, the buyer owns the car but will not get clear title until it is paid off.</p>

<p>Regardless of the structure, the documents should show the funds payable to the Qualified Intermediary. Funds paid to the taxpayer would constitute "<a href="/blog/what-cash-boot-1031-exchange" title="What is cash boot in a 1031 Exchange?">boot</a>" and therefore taxable.</p>

<h2>How does seller financing work with an exchange if the taxpayer is financing the buyer?</h2>

<p>This can be a bit tricky. For §1031 purposes, a taxpayer only has 180 days from the date of sale of the relinquished property to acquire the replacement property. For there to be total tax deferral, the full value of the sale property must be reinvested into the replacement property. But when seller financing is involved, the seller does not have the full value to roll over. There are times when the full value will be paid into the exchange account within the 180 day window but more often than not, it will be paid after the 180 day exchange period. So, payments coming into the exchange account can be used towards the acquisition of replacement property, but funds payable after that 180 day term cannot.</p>

<p>Although there are various ways to deal with this, the most common one is for the seller to “advance” the balance due for the replacement property with personal funds. Those funds can come from the taxpayer directly or can be borrowed by the taxpayer. The exchange balance plus the additional funds are used to acquire the replacement property. The note and mortgage or the installment sale agreement is then assigned from the Qualified Intermediary to the taxpayer. Since the necessary value was invested on a timely basis into the replacement property, the receipt by the taxpayer of principal payments over time under the financing document are not taxable.</p>

<h2>How does seller financing work with an exchange if the taxpayer is receiving financing from the Seller?</h2>

<p>This situation is not as complicated as when the taxpayer is financing the buyer. In any exchange, in order to have complete deferral, a taxpayer has to reinvest all the net proceeds from the sale and have equal or greater new debt compared to debt paid off at the relinquished property closing. Debt in the form of the balance due under the seller financing structure counts just like conventional financing, so it would typically offset the debt requirement to have equal or greater debt on the replacement property.</p>

<p>In summary, seller financing is a part of many real estate transactions. However, due to the rules around §1031 exchanges, some special steps need to be taken on account of the seller financing. If the taxpayer is selling, the loan must be documented so that the exchange company is the payee of the loan, and the applicable security interest should correspond. Once the loan document is monetized from a cash infusion by the taxpayer, the necessary amount can be exchanged into the replacement property. Ultimately, the security interest is assigned to the taxpayer and the taxpayer will not recognize any tax on the principal received over time due to the advancement of the funds at the time of the exchange. In the event the taxpayer is receiving the seller financing in connection with the purchase of the replacement property, such debt obligation is treated no differently than any other loan from a conventional financing source. The seller financing debt will offset debt paid off upon closing of the relinquished property.</p>

<p>Generally speaking, capital gains are any profits generated from the sale of assets. Further, people often refer to Section 1031 Exchanges as Tax Deferred Exchanges or Tax-Free Exchanges. The key language of the statute says that “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” On its face, the statute is a tool to defer capital gains taxes, not to avoid capital gains taxes.</p>

<h2>What is Capital Gains Tax?</h2>

<p>Capital gains tax is the tax that American taxpayers (both US citizens and non-citizens) pay on any profits (capital gains) generated from the sale of assets. Those assets include real estate, investments such as stocks, and businesses, among others. According to the IRS, those gains are to be considered taxable income. The IRS has different tax rates for capital gains based on the taxpayer’s income tax bracket, as well has how long the asset was held.</p>

<h2>Are There Variations of Capital Gains Tax?</h2>

<p>Assets that the taxpayer held for longer than one year result in long-term capital gains, while assets held for less than one year result in short-term capital gains. The Internal Revenue Code treats short-term capital gains the same as any other ordinary income so that the tax rate is the same as your income tax rate. Long-term capital gains at more favorable rates, as shown below.</p>

<p>For 2022, the tax brackets look like this:</p>

<drupal-media data-align="center" data-entity-type="media" data-entity-uuid="573a7615-2423-4604-9faf-f744f8c1fe4c"></drupal-media>

<h2>How is Capital Gains Tax Calculated?</h2>

<p>Generally speaking, if an asset is sold for more than its purchase price (it’s “cost basis”), there is a capital gain. On the other hand, if it is sold for less than it’s purchase price, there is a capital loss. But the Internal Revenue Code makes things a little more complicated, and calculates gain or loss based on the asset’s “adjusted basis.” To arrive at the adjusted basis, the taxpayer will start with the cost basis, and then add the cost of capital improvements, and subtract any depreciation taken. Note that only improvements to real estate can be depreciated, and the value of the land itself never depreciates. <a href="/depreciation-calculator" title="Depreciation Calculator"><em>Use our Depreciation Calculator.&nbsp;</em></a></p>

<p>To determine the final capital gains tax burden, the taxpayer would start by calculating the adjusted basis as described above, and subtract that from the current sale price; the difference is the capital gain. If the asset was held for longer than one year, the gain would be taxed according to the last column in the table above. If the asset was held for less than one year, the gain would be taxed as ordinary income based on the third column.&nbsp;<a href="/capital-gains-calculator" title="Capital Gains Calculator"><em>Use our Capital Gains Calculator.</em></a></p>

<h2>How Does Section 1031 Help with Capital Gains Taxes</h2>

<p>As noted above, Section 1031 provides that the gain on the exchange of an asset is not recognized in the year of the sale. Under the Internal Revenue Code, those gains are deferred, and will only be recognized at a time in the future when there is a taxable sale rather than another exchange.</p>

<p>A taxpayer can structure a transaction as a 1031 exchange in 2022, exchange that asset in 2025, exchange again in 2030, exchange again in 2032, and so on. Doing so would continue to defer the gains that accumulate between each sale. If that taxpayer ultimately sells the final asset in 2040, all of the deferred gains from each of those intervening 1031 exchange would be recognized.</p>

<p>But if the taxpayer is going to pay taxes at the end anyway, why exchange in the first place? There are two primary reasons that the taxpayer would structure those exchanges and then ultimately sell in a taxable transaction. First is the time value of money. Simply stated, the time value of money is the concept that a dollar today is worth more than a dollar tomorrow. Ask yourself this – would you rather pay someone $10,000 today, or ten years from now? Most investors would rather pay in ten years rather than today, preferably never if possible. The second reason is that theoretically, a taxpayer will sell their last investment property later in life, perhaps when they have past their peak earning years and are in a lower tax bracket. A married couple reducing their income from $650,000 to $200,000 would see their capital gains rate drop from 20% to 15% - a 25% reduction in the tax rate.</p>

<h2>Can Section 1031 be Used to Eliminate or Avoid Capital Gains Tax</h2>

<p>Using the scenario above, a taxpayer structures a transaction as a 1031 exchange in 2022, exchanges that asset in 2025, exchanges again in 2030, and exchanges again in 2032, before dying in 2035. Based on the Internal Revenue Code, that taxpayer’s heirs would inherit the final property at the fair market value as of the taxpayer’s death, receiving the property at a “stepped up basis.” The heirs do not need to worry about any accumulated depreciation or capital gains that a taxpayer had meticulously avoided through deferral, and they start with completely fresh basis. If the heirs were to sell the property shortly thereafter, there would be no capital gains to recognize.</p>

<p>By continuing to exchange throughout their life, this taxpayer successfully avoided all depreciation recapture and capital gains taxes. They effectively converted a tax deferred exchange into a tax-free exchange.</p>

<p>Section 1031 can be a powerful investment tool, and an incredibly useful estate planning tool. Taxpayers are encouraged to seek the advice of competent tax and legal counsel before structuring any 1031 exchange.</p>

<h2>Mixed-Use 1031 Exchanges</h2>

<p>A mixed-use exchange transaction occurs when a taxpayer sells property that includes their “primary personal residence,” and other land, structures, and other improvements used in a trade or business or held as an investment.</p>

<p>Some practical examples are:</p>

<ol>
<li>A home office where a business pays the taxpayer rent for office space within the principal residence;</li>
<li>Farm and ranch land where the taxpayer works the land as their business, but lives in their principal residence also located on the property;</li>
<li>A duplex where the taxpayer lives in one unit as their principal residence and rents the other unit; and</li>
<li>A single family home with an accessory dwelling unit (“ADU”), attached or detached, and the taxpayer lives in the home as their principal residence and rents out the ADU.</li>
</ol>

<p>The list is extensive, but mixed-use exchanges appear when there is a principal residence, commonly referred to as primary residence, on or within the land or building being conveyed as part of one transaction.</p>

<p>As a recap, Internal Revenue Code Section 1031(a)(1) provides: “In general no gain or loss shall be recognized on the exchange of property <em><a href="/blog/irc-section-1031-exchange-qualified-use-requirements" title="Qualified Use Requirements">held for productive use in a trade or business or for investment</a> </em>if such property is exchanged solely for property of like-kind which is to be held either for<em> productive use in a trade or business or for investment.</em>” This section of the tax code is a tool to defer gains.</p>

<p>Another provision in the code, Section 121, provides that a taxpayer, “regardless of age, may exclude up to $250,000 ($500,000 for married persons filing jointly) of gain on the sale or exchange of his or her primary residence if, during the five-year period ending on the date of the sale or exchange, the property has been owned by the taxpayer as the taxpayer’s principal residence for periods aggregating two years or more.” Unlike IRC Section 1031, IRC Section 121 excludes capital gain taxes on the sale rather than deferring the tax with no strings attached to how the taxpayer reinvest their sale proceeds.</p>

<p>So, <a href="/blog/1031-exchange-rules-vacation-homes-primary-residences-and-mixed-use-properties" title="1031 exchange for primary residence and vacation homes">how does a taxpayer take advantage of both sections of the tax code at the same time</a>? First, it’s important to identify your principal residence. A principal residence is not the taxpayer’s second home or vacation home which do not get the Section 121 benefit.</p>

<p>A principal residence is typically a taxpayer’s registered voting address, primary mailing address on your tax return, and other business documents, and the address on your driver’s licenses. As explained above, the principal residence may be part of a business use or investment property.</p>

<h2>Here are some frequently asked questions about the interplay between Section 1031 and Section 121:</h2>

<p>&nbsp;</p>

<h3>How is the exclusion amount calculated under IRC Section 121?</h3>

<p>Simply consider the original purchase price of the residential portion of the property and the cost of any improvements made to the residence, which is the adjusted basis. Next determine the value of that portion of the property that comprises the residence which is generally a reasonable area that is enjoyed in conjunction with the home. If the taxpayer desires some proof of value, a current market analysis may be obtained from a Realtor® and there are other considerations discussed below. A formal appraisal is another way to substantiate the valuation.</p>

<p>To determine the exclusion amount, the taxpayer will find out if they file their taxes jointly or singly. Single filers can exclude the basis plus an additional $250,000. Joint filers can exclude the basis plus an additional $500,000. The resulting amount is simply cash in the taxpayer’s pocket.</p>

<p>Commonly, taxpayers find themselves with one purchase and sale contract containing both personal residence and 1031 real property with no specific allocation of value to the personal residence. Valuing the residential portion separately is arguably more art than science. The Current Market Analysis mentioned above is one approach. Some value considerations when making the analysis are: (1) the per acre value for a defined small parcel rural residential homesite being greater than per acre value for the much larger farm or ranch acreage; (2) homeowners insurance valuation for the primary residence possibly (3) the current taxable assessed value; and (4) the valuation of other amenities with the homesite that are part of the taxpayer’s enjoyment of the home. This is not an exhaustive list, and taxpayers are encouraged to consult their CPA or tax attorney for additional guidance.</p>

<h3>How is the homesite defined in the context of the larger property being sold?</h3>

<p>Aerial photos are a great resource in determining the reasonable configuration of the homesite. It’s reasonable to conclude that the principal residence is comprised of not only the house, but well, septic and drain field, landscaping, shelterbelts, ponds, small pastures associated with pets and horses, and any other features that lend to the enjoyment of the residence. Those features can become quite evident from aerial photos.</p>

<p>The resulting analysis of value is a valuable document to be included in the taxpayer’s file as part of the transaction. The taxpayer and their advisors can rely on this resource to not only arrive at the exclusion amount but can reference it from the file if the excluded amount is ever be questioned by the IRS.</p>

<p>Consider this simple hypothetical:</p>

<ul>
<li>Total sale price $2,500,000</li>
<li>Principal residence valuation $800,000</li>
<li>Joint filing taxpayer’ basis in principal residence $300,000</li>
<li>Tax free cash to taxpayers $800,000.00</li>
<li>Section 1031 portion of the transaction $1,700,000</li>
</ul>

<h3>How can the 121 exclusion be used in the context of a property sale with debt payoff?</h3>

<p>The 121 exclusion can provide benefits in addition to putting tax free cash in the taxpayer’s pocket. Assume the property sale in the example above required debt payoff to a lender of $500,000. Normally the taxpayer would then be required to <a href="/blog/what-cash-boot-1031-exchange" title="Boot in a 1031 exchange">exchange equal or up in value</a> replacing $500,000 debt payoff with new debt or inserting new cash into the acquisition of the replacement property.</p>

<p>However, in our example, the taxpayer can allocate the debt payoff to the principal residence. That means the taxpayer doesn’t have to take on new debt or insert new cash into the replacement property acquisition and can retain the remaining $300,000 cash.</p>

<h3>How is the 121 exclusion documented at closing?</h3>

<p>Documenting the allocation of the sale proceeds partly to the personal residence exclusion and the 1031 exchange is relatively simple. The settlement statement for the relinquished property sale will contain a line item for “cash to exchanger (personal residence)” and a line item for “exchange proceeds to seller” which is the qualified intermediary.</p>

<h3>Are there other situations where the 121 exclusion does not apply?</h3>

<p>There are situations where the 121 exclusion cannot be used such as sales involving farms, ranches and other business properties which include the owners’ residences, but the entire property is owned by a corporation or partnership. Generally, the IRC Section 121 exclusion is available only to individuals, not S Corporations, C Corporations, or tax partnerships because these entities cannot own a principal residence. That said, <a href="/blog/same-taxpayer-requirement-1031-tax-deferred-exchange" title="Disregarded Entities in a 1031 exchange">business or other entities disregarded for tax purposes</a> (i.e. single- member limited liability companies, sole proprietorships, and grantor trusts) can use the Section 121 exclusion.</p>

<p>In the situations referenced above, it may be possible to distribute the personal residence on the ranch, farm, or other business property out of the entity prior to the sale and exchange. However, it is best to employ some advance planning to assure the distribution takes place at least two years before the sale.</p>

<p>To summarize, the Section 121 exclusion provides taxpayers with tax free cash and no reinvestment requirement. For the personal residence portion of a sale of business use property Taxpayers may also allocate the excluded amount to any debt payoff at sale and eliminate the debt replacement requirements for the 1031 portion of the transaction. There are also opportunities for taxpayers to acquire property in a 1031 exchange, hold the property for five years, live in a residence on the property for two of those five years and claim the Section 121 exclusion on the sale of the residential portion in a subsequent sale transaction.</p>

<p>Note, however, that when participating in a 1031 exchange, the taxpayer’s intent with regard to the replacement property should be that it will be “held for productive use in a trade or business, or for investment” indefinitely. Taxpayers are encouraged to seek the guidance of tax and legal counsel when structuring 1031 exchanges, or when considering changing the character of the investment property.</p>

<p>Previously, I discussed section 1031(f) of the Internal Revenue Code, <a href="/blog/1031-tax-deferred-exchanges-between-related-parties">the Related Party Rules</a>, introduced by Congress in 1989 to prevent taxpayers from manipulating the 1031 exchange rules to achieve a favorable outcome by entering into an exchange with a party related to them.</p>

<p>1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—</p>

<p style="margin-left:.5in;">(i) the related person disposes of such property, or</p>

<p style="margin-left:.5in;">(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”</p>

<p>We looked at the abuse that gave rise to the Related Party Rules and at which relationships are considered related parties. This week, we’ll examine common misconceptions of and exceptions to the Related Party Rules.</p>

<h2>Common Misconceptions</h2>

<h3>I can get around the Related Party rules using a Qualified Intermediary.</h3>

<p>Transacting an exchange through a Qualified Intermediary (QI) who is not a party related to the taxpayer does not “cleanse” the transaction when the seller is a related party. If the QI acquires the property from a party related to the taxpayer, the abuse is present, just as it would be if the taxpayer traded directly with the related party.&nbsp; The catch-all provisions of §1031(f)(4) make clear that “This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.”&nbsp; Simply acquiring the related party’s property through the unrelated QI does not change the outcome. The IRS position on this scenario was the subject of <a href="http://www.irs.gov/pub/irs-drop/rr-02-83.pdf&quot; target="_blank">Revenue Ruling 2002-83</a>.</p>

<h3>I looked it up and discovered it’s ok as long as I hold the replacement property for two years.</h3>

<p>Many people, including professional advisers, see the two year holding exception to the application of the related party rules and believe that, should the taxpayer acquire replacement property from a related party and hold the property for at least two years, the prohibition is nullified.&nbsp; Unfortunately, this exception only applies if <u>both</u> the taxpayer and the related party hold the respective properties received in the exchange with one another for a minimum of two years.&nbsp;</p>

<p>In a more typical related party scenario, the taxpayer’s relinquished property is sold to a third party and the replacement property acquired from a related party.&nbsp; Since they are not exchanging with one another, the exception by its terms does not apply.&nbsp; The related party cannot hold the taxpayer’s relinquished property since that property was transferred to a third party buyer. &nbsp;Only in the very narrow instance in which two related parties are exchanging with one another and they each hold the properties for two years or more does this exception apply.</p>

<h2>Are there any other exceptions to Related Party Rules?</h2>

<p>As indicated above, the two year holding exception has limited applicability, applying only to exchanges between taxpayers who receive (and hold) each other’s property. Under this exception, if the properties are held for a minimum of two years, there is a presumption that the trade was motivated by reasons other than “abusive basis shifting.”</p>

<p>Another exception, under Section §1031(f)(2)(C), provides for an earlier than two year disposition of a property that is part of a related party transaction. This section states that the transaction will not be disqualified if, “with respect to which it is established to the satisfaction of the [Treasury] Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.”&nbsp; Most exchanges involve tax deferral so it is difficult to make this case.&nbsp; There have, however, been favorable IRS rulings in which family members exchanged undivided interests in several properties in order to allow each to own a whole. This is a perfect example of this exception.</p>

<p>An additional exception is based upon a series of private letter rulings beginning with <a href="http://www.irs.gov/pub/irs-wd/1220012.pdf&quot; target="_blank">PLR 201220012</a> which pertained to a taxpayer’s disposal of replacement property within the two year period.&nbsp; The ruling concluded since the related party did an exchange from that property into another, there was no cashing out and therefore no tax abuse.</p>

<p>Finally, a seldom-used exception to the requirement of both parties retaining the property for two years or more occurs in the event of the death of the taxpayer or the related person.&nbsp; Such an event will allow for the exchanged property being sold within the two year period while maintaining the original deferral.&nbsp; Taxpayers will do just about anything to avoid paying tax, but this is clearly not a strategy that anyone will want to employ.</p>

<h2>Summary</h2>

<p>The exceptions to the prohibitions of the Related Party Rules have in common the notion that the involvement of the related party is attributable to reasons other than allowing the taxpayer to cash out while selling a low basis property to a third party. Learn more about 1031 Related Party Rules in my original post, <a href="/blog/1031-tax-deferred-exchanges-between-related-parties">1031 Tax Deferred Exchanges Between Related Parties</a>.</p>

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<p><em>Updated 7/20/2022.</em></p>