What Are the 1031 Related Party Rules?

An exchange of real estate under Internal Revenue Code Section 1031 allows an investor to defer paying capital gains taxes. This is done by selling an investment property and reinvesting the proceeds into a new, “like-kind” property. The rules for these transactions become more restrictive when the exchange involves individuals or entities with a pre-existing relationship to prevent what is known as basis shifting.

The concern of the Internal Revenue Service (IRS) is that related parties could use an exchange to improperly reduce a tax liability. For example, a party with a low-basis property could swap it with a related party who owns a high-basis property. The related party could then sell the newly acquired low-basis property and pay little to no tax, effectively cashing out of the investment without recognizing the taxable gain.

Defining a Related Party

For a 1031 exchange, the term “related party” is defined by the Internal Revenue Code, primarily in Sections 267 and 707. These definitions are broad and encompass a wide range of both familial and business relationships. Understanding these classifications is necessary before structuring a transaction that might involve a connected individual or entity.

Family relationships are a primary focus. This includes:

• An individual’s spouse
• Siblings
• Ancestors, such as parents and grandparents
• Lineal descendants, like children and grandchildren

Relationships like aunts, uncles, nieces, nephews, and cousins are not considered related parties under these statutes.

The rules also extend to business and entity structures. A corporation is a related party if an individual directly or indirectly owns more than 50% of the value of its outstanding stock. A partnership is a related party to a person who owns more than 50% of the capital interest or the profits interest in that partnership.

These entity rules also apply between different organizations. Two corporations can be related parties if they are members of the same controlled group. A corporation and a partnership are deemed related if the same persons own more than 50% of both the corporation’s stock and the partnership’s capital or profit interest. The code also specifies relationships involving trusts, such as a fiduciary of a trust and its beneficiary.

The Two-Year Holding Requirement

The main related party rule is the two-year holding requirement. This regulation stipulates that when a taxpayer completes a 1031 exchange with a related party, both the taxpayer and the related party must hold their respective properties for a minimum of two full years. If either party disposes of their property within this two-year window, the tax deferral from the original exchange is invalidated for the initial exchanger.

This rule prevents “cash-out” scenarios. For instance, a sister could own a rental property with a low tax basis, and her brother could own a high-basis property. They could swap properties in a 1031 exchange, and without the holding period, the brother could immediately sell the low-basis property he received, realizing cash while recognizing little taxable gain.

The two-year clock begins on the date of the final transfer that completes the exchange. In a deferred exchange that uses a qualified intermediary, the clock starts for both parties once the taxpayer acquires their replacement property. A disposition even one day short of the two-year mark can trigger the tax consequences.

This holding requirement applies regardless of whether the exchange is a direct swap or involves a qualified intermediary. A common structure involves a taxpayer selling their property to a third party and then acquiring their replacement property from a related party. This transaction is still subject to the two-year holding rule.

Exceptions to the Holding Requirement

The tax code provides specific exceptions that permit an early disposition of a property without triggering the tax consequences. These exceptions recognize that certain life events or external circumstances are not motivated by tax avoidance. A disposition that falls into one of these categories will not invalidate the original tax-deferred exchange.

The first exception is the death of either the taxpayer or the related party. If either individual dies before the two-year holding period expires, any subsequent disposition of the property is permitted without voiding the tax deferral. The transfer of property to an heir as a result of the death is not considered a disqualifying disposition.

A second exception applies in the case of an involuntary conversion of one of the properties. This refers to events beyond the owner’s control, such as the destruction of the property by a natural disaster, its theft, or its seizure by a governmental authority. For this exception to apply, the exchange must have occurred before the threat or imminence of the conversion.

The final exception is more subjective. A disposition within the two-year period may be allowed if it can be established to the satisfaction of the IRS that neither the initial exchange nor the subsequent disposition had tax avoidance as a principal purpose. Proving this requires demonstrating a compelling, unforeseen change in circumstances, such as a sudden health crisis or an unexpected business opportunity that necessitates the sale.

Tax Consequences of a Failed Exchange

When the two-year holding rule is violated and none of the exceptions apply, the tax deferral from the original 1031 exchange is retroactively lost. The gain that was initially deferred must be recognized and reported as taxable income, meaning the investor loses the primary benefit of the transaction.

The gain is not reported by amending the tax return for the year of the original exchange. Instead, the gain is recognized in the tax year in which the disqualifying disposition occurs. For example, if the exchange took place in 2023 and the related party sells their property in 2024, the original taxpayer must report the deferred capital gain on their 2024 tax return.

The taxpayer’s income level and applicable capital gains tax rates in the year of the disqualifying sale will determine the final tax liability. The transaction is reported on IRS Form 8824, Like-Kind Exchanges. This form is filed for the year of the early disposition, and it is where the previously deferred gain is calculated and carried over to the taxpayer’s main return.

The failure of the exchange effectively converts a tax-deferred event into a taxable sale. The taxpayer will be liable for federal capital gains tax, any applicable net investment income tax, and state income taxes on the gain.