The Dictionary of Real Estate Appraisal defines an arm's length sale as "A transaction between unrelated parties who are each acting in his or her own best interest.” If there is a business or personal relationship between the seller and buyer, the transaction is not considered to take place "at arm's length." Instead, this sale is an example of a related party transaction.
How do arm’s length rules affect 1031 exchanges?
A 1031 exchange is a tool that investors can use to defer the payment of capital gains taxes when they sell one investment property and reinvest the proceeds into another. It's not a simple transaction, and the investor must carefully adhere to the rules and timelines to qualify for the deferral. One significant provision is that the investor may not have access to the proceeds from the initial sale during the time between that disposition and the purchase of replacement properties.
To achieve the necessary separation, the investor uses a Qualified Intermediary to manage the process and hold the proceeds in an account unavailable to the investor. The QI (also called an Exchange Accommodator) may not be related to the investor nor be a business associate or agent.
Further, the IRS restricted related-party transactions by stipulating that the acquirer cannot sell any property acquired in a related-party 1031 exchange for at least two years. This regulation aims to eliminate basis-shifting, which can avoid recognition of capital gains. If a taxpayer trades a low-cost basis property for a high-cost basis property through a transaction with a related party, they can reduce the capital gains tax when they sell the lower-cost property.
If either party sells the property within two years of the exchange, the IRS will disqualify the transaction. There are exceptions to the two-year rule:
- Death of either party
- Involuntary conversion of one of the properties
- Ability to prove that the motivation for the sale was not tax avoidance
Does an arms-length requirement impact fair market value?
The Fair Market Value (FMV) of property is the value as determined by the marketplace. The marketplace is an objective purchaser, not an interested party. Therefore, to ensure that you are selling for FMV, you must complete the transaction at arm's length. For real estate, FMV is determined by evaluating the recent sales of comparable properties (similar properties nearby). If that is inadequate, the seller can substitute an expert appraisal.
If you sell your property to a relative, you might not get Fair Market Value. You may be interested in selling at a lower price, and the relative may be interested in paying less than the property is worth. These considerations affect whether a 1031 exchange transaction can be qualified for deferring the capital gains taxes.
Ensuring that your 1031 exchange transactions are completed using Fair Market Value can help with potential consideration for qualification, particularly in a non-arm's length situation.
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.
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.
Hypothetical examples shown are for illustrative purposes only.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
