Our team often hears from real estate investors who are wondering whether they can engage in a 1031 exchange with a family member or other related parties. While it is sometimes possible, it’s a bit more complex than a standard 1031 exchange.
The IRS has strict guidelines in place to help avoid potential abuse by taxpayers who are simply seeking tax avoidance. Prior to engaging in a 1031 exchange with a related party, it’s important to fully understand the regulations.
What is a Related Party?
Sections 707(b) and 267(b) of the Internal Revenue Code define related parties as a person or entity that has a relationship with the exchanger. This includes immediate family members such as parents, siblings (whole or half), spouses, ancestors, and lineal descendants.
Also included are partnerships, corporations, and entities in which more than 50% of the stock or capital interest is directly or indirectly owned by the taxpayer. Trusts that control property for the benefit of the taxpayer are also considered related parties. In addition, an executor is deemed to be related to an estate’s beneficiaries.
While the scope of related parties may seem quite wide, it’s important to note that some relatives are excluded. This includes in-laws, stepparents, aunts and uncles, cousins, nieces and nephews, and ex-spouses.
IRS Rules Regarding Related Party 1031 Exchanges
Related party 1031 exchanges were first addressed in 1989 with the addition of subsection 1031(f) to Section 1031. It was later clarified and solidified in 2002 with Revenue Ruling 2002-83. This ruling stated that taxpayers can defer capital gains taxes through a 1031 exchange with a related party if the following three conditions are met:
1. Both parties must hold the properties for a minimum of two years following the exchange
2. Transaction details such as the sale price and rental income must be at prevailing market rates
3. The taxpayer must be able prove that the transaction did not result in tax avoidance through income tax basis swap
The two-year holding period begins on the date of the last transfer. However, you may still qualify for a 1031 exchange with a holding period of less than two years if either of the parties dies before the two years have passed or you can prove that tax avoidance was not the purpose of the exchange.
Related Party Transactions
While the rules above provide a general guideline, it’s also important to note that every transaction between related parties is unique. Qualification for tax deferral will depend on whether you are buying, selling, or swapping properties. Let’s take a closer look at each scenario.
Swapping Properties with a Related Party
Under IRS guidelines, related parties can successfully complete a 1031 exchange by swapping separately owned properties, if they meet the guidelines described above.
Selling to a Related Property
Selling a property to a related party and buying a like-kind replacement property from an unrelated party is generally allowed. However, the transaction must be completed through a qualified intermediary (QI) and the two-year holding period still applies.
Buying From a Related Party
Generally, buying a property from a related party and selling it to an unrelated party is not allowed. IRS Ruling 2002-83 states that buying property from a related party violates the terms of subsection 1031(f).
However, there is an exception. If you’ve used a qualified intermediary, the transaction may qualify as a 1031 exchange if:
1. The related party uses the proceeds from your purchase to complete their own 1031 exchange and
2. You can prove that the transaction did not result in tax evasion
The Bottom Line
While engaging in a 1031 exchange with a family member is possible, it should be approached with caution. If you decide to move forward, do so with the understanding that the IRS will likely examine the transaction to confirm that all the rules and guidelines have been followed.
When engaging in complex financial transactions such as a related party 1031 exchange, it’s a good idea to consult with a tax advisor and other professionals who are well-versed in the process and will be able to complete and sign off on related tax reporting documents. If you would like more information, we invite you to contact us to schedule a consultation.
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