Can You Do A 1031 Exchange With A Family Member?

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.

Performing a 1031 exchange can be an excellent investment strategy for both parties. Each may pursue their goals by correctly completing the exchange. An exchange transaction with a related party could make sense due to familiarity, but both parties must be vigilant about following the IRS rules.

If you are interested in conducting a 1031 exchange with a related party, carefully evaluate whether the benefits of the transaction outweigh the added risk of disqualification by the IRS. If the transaction is not allowed by the IRS, both parties will need to recognize the gain in the year the transaction took place. However, in circumstances where the parties can both achieve their financial and investing goals, the move can be completed through careful planning.

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 with a relationship with the taxpayer. Regarding immediate family members, this includes parents, siblings (whole or half), spouses, ancestors, and lineal descendants. However, this definition 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 the taxpayer directly or indirectly controls more than 50% of the stock or more than 50% of the capital interest. Control of the property by a trust for the taxpayer's benefit 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 with a related party for a high-cost basis property. By doing this, the taxpayer was given an advantage by eliminating or reducing capital gains tax on selling 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 for the taxpayer exchanging property with a related party unless the taxpayer or related party disposes of the property within two years of the exchange. 

The IRS' Revenue Ruling 2002-83 solidified the IRS' position on a related party transaction. You may 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, or you can prove that this transaction did not result in tax avoidance through income tax basis swap. 

Due to the potential for basis-shifting, the IRS looks closely at any related-party 1031 exchange. However, while selling to a related party as part of the exchange is feasible if the parties abide by the two-year holding period, buying from a related party is more challenging.

The Two-Year Holding Period

The taxpayer and related party are required to hold the 1031 exchange properties for a minimum of two years. This holding period begins on the date of the transfer. There are exceptions to this two-year rule as follows:

• Death of the taxpayer or related party;
• The compulsory or involuntary conversion of one of the properties;
• You can prove tax avoidance was not the purpose of the exchange;

The IRS ruling provides clear guidance on attempting a 1031 exchange with a family member. These rules prevent taxpayers from taking advantage of the system and preclude the possibility of tax avoidance through a shift basis. In addition, the IRS and tax courts will look at the tax results of the transaction to determine whether the parties followed the rules.