How do intermediaries affect related-party exchanges?

Sec. 1031 provides for deferral of gain or loss realized on an exchange of property when the taxpayer acquires property of a like kind. Sec. 1031(f) provides special rules when the like-kind exchange is between related parties. In such a case, if the taxpayer disposes of the like-kind property received from the related party, or the related party disposes of the property received from the taxpayer, with either disposition occurring within two years of the exchange, the taxpayer must recognize all the gain on the initial exchange. Such gain is reported in the tax year in which the disposition occurs.

Like-kind exchanges must be reported on Form 8824, Like-Kind Exchanges. In Part I of the form, the taxpayer is asked, among other things, whether the exchange was with related party. If the taxpayer answers "yes," he must then complete Part II, which asks for identifying information with respect to the related party and for details of any dispositions by either party within two years.

Some Sec. 1031 exchanges, particularly deferred exchanges, make use of a qualified intermediary. By using a qualified intermediary, together with assignments of contract rights, the overall transaction may be treated as if a direct exchange had occurred between the taxpayer and the intermediary. What occurs if a related party is either the buyer of the relinquished property or the seller of the replacement property, with a qualified intermediary used to complete a deferred exchange? The immediate issue to address when filing the taxpayer's return for the year of the exchange is whether the related-party section of Form 8824 must be completed. A subsequent issue is whether a disposition of property by either related party will trigger the taxpayer's deferred gain. There are no answers to these questions in Sec. 1031 or the regulations thereunder.

The Treasury Department may have recently signaled its views on the application of related-party rules to deferred exchanges using a qualified intermediary. Sec. 168(g) restricts the use of certain cost recovery methods when property is used by a tax-exempt party, including the lease of property to a tax-exempt party. In April 1996, the IRS issued final regulations on related-party like-kind exchanges designed to circumvent the restrictions on cost recovery methods for tax-exempt use property. For example, an exchange of low-basis property leased to a taxpaying lessee for high-basis property leased to a tax-exempt lessee would be covered, since the difference between the high and low basis would otherwise escape the Sec. 168(g) limitations. Regs. Sec. 1.168(h)-1(b)(2)(i) provides that Sec. 168(g) limits will apply when the taxpayer acquires property for cash, but Sec. 1031 nonetheless applies to the related party because a qualified intermediary was used. The related-party exchange rules applicable to Sec. 168(g) will apply even when the tax-exempt use property was acquired from a qualified intermediary, rather than the related party.

The adoption of Regs. Sec. 1.168(h)-1 suggests that the Service may disregard the form of an exchange involving a qualified intermediary and instead contend that any multi-party exchange that involves either a purchase or a sale with a related party is a transaction governed by Sec. 1031(f) that must be reported as a related-party exchange on Form 8824. However, the Sec. 1031 regulations are silent as to the interaction of the qualified intermediary and related-party exchange rules. Interpretive regulations issued under Sec. 168 do not automatically apply to Sec. 1031.

One concern with reporting an intermediary exchange as a related-party exchange is that a disposition of the property received by either party may trigger deferred gun. Intermediary exchanges confound the interpretation of Sec. 1031(f) because the related party on one side of the exchange may receive money. A "disposition" of that money would not be expected to deny continued gain referral to the related party on the other side of the multi-party exchange. Form 8824 supports this interpretation, but the language of Sec. 1031(f) appears at odds with the language used in Form 8824 with respect to related-party dispositions.

Sec. 1031(f)(1)(C) states that a tax-payer's realized gain from an exchange of property with a related party may be recognized if either:

1. the related party disposes of such property (the property received from the taxpayer) or

2. the taxpayer disposes of the property received in the exchange from the related person that was of like kind to the property transferred by the taxpayer.

Sec. 1031(f)(1)(C) refers to a disposition of property received by the related party, without regard to whether such property was like kind to the relinquished property. However, question 9 in Part II of Form 8824 asks whether the related party disposed of the "like-kind property received from the exchange." If a related party in an intermediary exchange receives money or a note, and not like-kind property, presumably, gain is triggered only if the taxpayer disposes of like-kind replacement property received in the exchange. Treasury should update the Sec. 1031 regulations to explain how Sec. 1031 (f) applies to multi-party intermediary exchanges involving related parties.