Section 1031 of the Internal Revenue Code allows owners of real estate investment properties an important tax break: the ability to defer capital gains and other taxes when they exchange one investment property for a replacement asset.
There are many important regulations that must be followed to the letter to ensure your exchange is never challenged or disqualified by the IRS. Section 1031(f) outlines special rules for transferring property between related parties, which is anyone who has a relationship with the exchangor.
In this article we’ll take a closer look at related party rules for 1031 exchanges to help investors more clearly understand this key provision of the exchange process.
Related-Party Rules Explained
The basic principle of a 1031 exchange is that taxpayers won’t recognize any gain or loss when exchanging real property that’s held as an investment so long as they exchange that asset for a like-kind property that’s also held for investment purposes. Exchangors have 45 days from close of sale on their original assets to identify a replacement property, and 180 days total to close on the new asset. They also can’t take receipt of any funds during the process and must use a Qualified Intermediary to facilitate all aspects of the exchange.
Exchange rules can get rather sticky when it comes to exchanging properties with a “related person,” though. Related party rules are defined in IRS Section 267(b)¹ and 707(b). Related parties include family members such as spouses, siblings, and other lineal descendants. Additionally, a taxpayer who owns at least 50 percent of a corporation or partnership is considered a related party to that entity.
Section 1031(f), meanwhile, addressed in Rev. Ruling 2002-83², states the following:
“A taxpayer exchanging like-kind property with a related person cannot use the nonrecognition provisions of § 1031 if, within 2 years of the date of the last transfer, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. The taxpayer takes any gain or loss into account in the taxable year in which the disposition occurs.”
Cutting through the clutter, the above statement means that you certainly can do a 1031 exchange with someone related to you. However, both the taxpayer and the related party must hold their exchanged assets for a minimum of two years. If either party disposes of exchanged properties before that 24-month timeframe, the exchange will be disqualified for both parties since the IRS views the intent of early disposition as a cash-out rather than holding the properties for investment purposes.
Exchange rules can be even stickier if you are trying to buy a property from a related party as part of a 1031 exchange. The IRS has largely disqualified these types of exchanges because of the likelihood for basis shifting, even if this was never the intent of exchangors³. If the taxpayer receives beneficial tax treatment such as shifting in basis by exchanging with a related party, the exchange will be disqualified. Exchanges without a shift in basis theoretically should be allowed, but exchangors in these circumstances are swimming in choppy waters and should understand that their exchanges could be challenged by the IRS.
The Bottom Line
There are a few exceptions to the rules and limitations outlined in 1031(f). For instance, a related party may dispose of an exchanged asset within that two-year holding period if one of the related parties dies. Real property owners who plan to complete a 1031 exchange with a related party should be able to successfully complete an exchange provided they adhere to the covenants outlined in this article. Discussing your exchange plans with qualified legal and tax professionals is paramount to ensuring a successful exchange in these instances.
1. U.S. Code 267 – Losses, expenses and interest with respect to related taxpayers, Cornell Law School Legal Information Institute, https://www.law.cornell.edu/uscode/text/26/267
2. Section 1031 – Exchange of Property Held for Productive Use or Investment, IRS.gov, https://www.irs.gov/pub/irs-drop/rr-02-83.pdf
3. Section 1031 Related-Party Exchanges and Basis Shifting, The Tax Adviser, https://www.thetaxadviser.com/issues/2011/oct/clinic-story-06.htmlThis material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.