Doing a 1031 exchange with an immediate family member raises red flags with the IRS. Tax-deferred exchanges between family members are allowed, but the IRS has specific rules to qualify and avoid abuse of the system by tax evaders.
What is a Related Party?
The IRS defines a related party under IRC Section 707(b) or Section 267(b) as an individual or entity that has a relationship with the taxpayer. As far as immediate family members, this includes parents, siblings (whole or half), spouses, ancestors, and lineal descendants. This does not include in-laws, stepparents, aunts or uncles, cousins, nieces or nephews, or ex-spouses.
A related party isn’t only a direct family member. Another example is a partnership, corporation or entity in which more than 50% of the stock or more than 50% of the capital interest is directly or indirectly owned by the taxpayer. Control of the property by a trust for the benefit of the taxpayer is also considered related.
The Problem With Related Party Transactions
Before restrictions regarding 1031 exchanges with related parties, the IRS noticed some taxpayers were taking advantage by buying and selling from related parties to shift basis. Basis shifting is where a taxpayer trades a low-cost basis property for a high-cost basis property with a related party. By doing this, the taxpayer was given an advantage by eliminating or reducing capital gains tax on the sale of the low-cost basis property.
In 1989, the IRS added subsection (f) to Section 1031 to limit exchanges involving related parties. Section 1031(f) states that there is a non-recognition of gain or loss to the taxpayer exchanging property with a related party if the taxpayer or related party disposes of the property within two years of the exchange.
The 2002 Revenue Ruling 2002-83 solidified the position of the IRS on a related party transaction. You’re authorized to defer income tax liability through a 1031 exchange with a related party so long as both parties hold the replacement property for a minimum of two years following the exchange, and you can prove that this transaction did not result in tax avoidance through income tax basis swap.
The Two-Year Holding Period
The taxpayer and related party are required to hold the properties from the 1031 exchange for a minimum of two years. This holding period begins on the date of the transfer. There are exceptions to this two-year rule and are as follows:
- Death of the taxpayer or related party;
- Under IRC 1033, the compulsory or involuntary conversion of one of the properties;
- You can prove tax avoidance was not the purpose for the exchange;
The ruling given by the IRS provides clear guidance on attempting a 1031 exchange with a family member and should be approached with caution. These rules are to prevent taxpayers from taking advantage of the system and to circumvent the possibility of tax avoidance through shift basis. The IRS and tax courts will look at the tax results from the transaction to determine whether these rules were followed.
The 1031 Investor's Guidebook
Tackle the art and science of completing your 1031 exchange.