Selling to a relative, buying from your own company, or trading properties with a family member can all be part of a 1031 exchange. But the tax code has special rules for exchanges between related parties, and they are one of the most common reasons an exchange that looked fine at closing fails later. Here is how the rules work and which transactions they affect.
Why the related party rules exist
Without these rules, related parties could use an exchange to move tax basis around. For example, a family member could trade a low-basis property for a relative's high-basis property, and the relative could then sell the low-basis property and pay little or no tax. Congress added Section 1031(f) to stop this kind of basis shifting.
Who counts as a related party?
Section 1031(f) borrows its definition from other parts of the tax code (Sections 267(b) and 707(b)(1)). Related parties include:
- Close family: your spouse, brothers and sisters (including half-siblings), parents, grandparents, children and grandchildren.
- Entities you control: corporations and partnerships in which you own more than 50%, directly or indirectly.
- Related entities: two corporations or partnerships under the same majority ownership, and certain trust, fiduciary and beneficiary relationships.
In-laws, aunts, uncles, cousins, nieces and nephews are generally not related parties under these rules, but ownership can be attributed through family members and entities, so check with your CPA if an entity is involved.
The two-year rule
The core rule is simple. If you exchange property with a related party, both of you must keep the property you received for two years after the exchange. If either of you sells or otherwise disposes of it within two years, the gain you deferred becomes taxable, reported in the year of that later disposition.
The two-year clock can be paused. Under Section 1031(g), any period during which the holder's risk of loss is substantially reduced, for example by an option to sell the property or a similar arrangement, doesn't count toward the two years.
Exceptions
Section 1031(f)(2) allows a disposition within two years without triggering the gain in three situations:
- The death of either you or the related party.
- An involuntary conversion, such as a condemnation or casualty, as long as the exchange happened before the threat of conversion.
- When it is established to the IRS's satisfaction that neither the exchange nor the later disposition had tax avoidance as one of its principal purposes.
The last exception is narrow and fact-specific. Don't plan around it without advice from your CPA or attorney.
Three common situations
1. Swapping properties directly with a relative
Two related parties can trade properties with each other and both defer gain, as long as each keeps the property they received for two years. This is the situation the statute was written for.
2. Selling your property to a related buyer
You sell your relinquished property, through your qualified intermediary, to a related party, and buy your replacement property from an unrelated seller. This is generally acceptable. The related buyer pays cash, and no basis shifting occurs because the replacement came from a stranger. The IRS has approved this pattern in several private letter rulings. To be safe, both you and the related buyer should plan to hold your properties for at least two years.
3. Buying your replacement property from a related seller
This is where most problems arise. In Revenue Ruling 2002-83, the IRS ruled that an investor who buys replacement property from a related party, through a qualified intermediary, does not qualify for exchange treatment if the related seller ends up with cash. Using an unrelated intermediary doesn't help: Section 1031(f)(4) denies the exchange when a transaction is structured to avoid the related party rules. The Tax Court reached a similar result in the Teruya Brothers case.
The IRS has allowed purchases from a related seller in some private letter rulings, but only when the related seller was also doing its own 1031 exchange, neither party was cashing out of real estate, and both held their new properties for two years. Private letter rulings protect only the taxpayer who requested them, so treat this as an exception that needs careful planning, not a general rule.
Reporting a related party exchange
A related party exchange is reported in Part II of Form 8824 with your tax return for the year of the exchange. You must also file Form 8824 for each of the two years after the exchange, confirming whether either party has disposed of the property. See our guide to reporting an exchange on Form 8824.
Practical steps
- Tell your intermediary early. Disclose any family or ownership relationship with the buyer or seller before you sign contracts, so the exchange can be structured correctly.
- Look at both sides. The question isn't just who you're selling to, but who you're buying from.
- Plan for two years. Make sure both parties can realistically hold their properties for the full period.
- Get advice on entities. Ownership through LLCs, partnerships and trusts can create a related party relationship you didn't expect.
If a family member or one of your companies is on either side of your exchange, contact us before you sign a purchase agreement. We will work with your CPA and attorney to confirm the structure while there is still time to change it.
This article is general information, not tax or legal advice. Talk to your CPA or attorney about your situation.
