As we’ve mentioned in numerous blogs, 1031 exchanges come with many rules and regulations. These include in-stone deadlines, the value of relinquished and replacement properties, and eligible properties.
Then there are related property exchanges. These involve tax-deferred exchanges between family members. But the IRS has many rules in place to decrease the potential for abuse.
The related property exchange—also known as the related property rule—is the process of conducting a 1031 exchange between family members. According to the IRC Section 707(b) and 267(b), a related property is defined as a spouse, ancestor, or lineal descendant (this can include step/half brothers and sisters or adopted children). This also includes non-family members, like partnerships, corporations, or other entities in which the taxpayer controls more than 50% of the stock or 50% of the capital interest.
However, “related” members do not include in-laws, step-parents, aunts, uncles, cousins, nieces or nephews, or ex-spouses.
In the past, taxpayers exchanged property with relatives without specific restrictions. But the IRS realized that many of these related-property transactions underwent basis shifting. This meant taxpayers had an advantage when selling or exchanging property. Basis shifting is swapping high-basis properties (with higher tax rates) with low-basis properties (which have lower tax rates).
The IRS attempted to curb these abuses through its Revenue Ruling 2002-83. One important factor in this ruling is that the taxpayer and related party must hold properties of a 1031 exchange for a minimum of two years.
Another rule is that if a replacement property seller is related to the taxpayer, the exchange might not qualify for tax deferral. And finally, an exchange might raise red flags with the IRS if it’s part of a transaction put in place to fully avoid federal income tax payments. Even if basis shifting isn’t involved, the exchange might be disallowed if the related seller ends up paying less tax on the sale of a replacement property than the taxpayer might have paid on selling their relinquished property.
Specifically, under the conditions of Section 1031(f), the IRS has the right to invalidate an exchange if the taxpayer can’t prove that the process avoided otherwise-due taxes.
Participating in a 1031 exchange requires attention to the rules and regulations. This is especially the case in a related property exchange. Yes, it’s possible to enter into an exchange with a child, spouse, or even a business partner. But the chances that the process might be disallowed can be higher in a related party exchange. Before taking that first step, it’s essential to discuss the process with a qualified professional.