1031 Exchange Rules — Related Parties

A related party exchange under Section 1031 of the Internal Revenue Code, involves the exchange of property between parties who have a close business or familial relationship. Section 1031 allows taxpayers to defer capital gains taxes on the exchange of like-kind properties held for productive use in a trade or business or for investment. However, the IRS imposes stricter rules for exchanges involving related parties to prevent tax avoidance. 

Leila Bradley, CES®

Who is considered a related party?

The Internal Revenue Code, Sections 267(b) and 707(b) define related parties as family members (siblings, spouses, ancestors, and lineal descendants) and entities in which the taxpayer has a significant ownership interest (e.g., partnerships, corporations, trusts).

Selling your Relinquished Property to a Related Party:

The IRS typically considers a 1031 exchange, where a taxpayer disposes of a relinquished property to a related party and acquires a replacement property from an unrelated party, as a transaction that does not involve basis shifting or tax evasion. This is because the taxpayer transfers their low basis to a property that is held by an unrelated party. Though selling relinquished property to a related party is generally considered safe and allowed by the IRS, taxpayers should always discuss selling property to a related party with their tax advisor.

Purchasing your Replacement Property from a Related Party:

Exchanges in which the relinquished property is sold to an unrelated party, but the replacement property seller is a related party are unlikely to qualify for tax deferral unless the related party seller is also completing a 1031 exchange.  In a situation where the taxpayer is buying a replacement property from a related party seller, but the seller is not also doing an exchange, this can be seen by the IRS as basis shifting or intentional tax avoidance and will likely be disallowed.  

Related Party Swap

When a taxpayer sells relinquished property to a related party as part of a 1031 exchange and purchases a replacement property from the same related party, this is known as a related party swap.  These transactions are generally allowed by the IRS as long as both parties hold their respective replacement properties for the required holding period.

Holding Period Requirement:

Both parties involved in a related party exchange must hold the exchanged property for at least two years after the exchange to qualify for tax deferral. If either party disposes of the property within this period, the exchange may lose its tax-deferred status, and the capital gains taxes may become due retroactively.

What is Basis Shifting?

Basis shifting is where a taxpayer with a low basis trades properties with a related taxpayer with a high basis. This is done to eliminate or reduce capital gains taxes on the sale of the property that originally had a low basis (and now in the hands of the related party has a high basis).  

Initial Basis Determination:  The basis of a property is typically its purchase price plus capital improvements, minus depreciation. When a property is exchanged under Section 1031, the basis of the old (relinquished) property is transferred to the new (replacement) property, adjusted for any additional cash or other property received in the exchange.

Taxpayers must report related party exchanges on Form 8824, "Like-Kind Exchanges," providing detailed information about the transaction and the parties involved.  The IRS scrutinizes related party exchanges to ensure that they are not used to manipulate the tax code. If the exchange appears to be structured primarily for tax avoidance rather than legitimate business purposes, the IRS may disqualify it.

Towne 1031 Exchange does not provide tax or legal advice. Please consult an accountant and/or attorney.