In a 1031 exchange and Qualified Opportunity Funds (QOFs), the term related party refers to individuals or entities that have a close relationship with the taxpayer, such that transactions between them may not be considered arm’s length. The IRS has specific rules governing transactions between related parties to prevent tax avoidance.
1031 Exchange
Under Section 1031 of the Internal Revenue Code (IRC), a related party is generally defined as:
- Family members, including siblings, spouse, ancestors (parents, grandparents), and lineal descendants (children, grandchildren).
- An entity, such as a corporation or partnership, in which the taxpayer owns more than 50% of the stock or interest.
- Any two entities or individuals that are under common control, as defined by the IRS.
In a 1031 exchange, if you exchange property with a related party, certain restrictions apply. For example, both parties must hold the exchanged properties for at least two years after the exchange. If either party sells the property within that period, the exchange may be disqualified, and the deferred gain might become taxable.
Qualified Opportunity Funds (QOF)
In the context of QOFs, a related party is defined similarly, focusing on the potential for non-arm’s length transactions. The IRS rules for QOFs are designed to prevent taxpayers from using related parties to circumvent the intent of the tax deferral benefits.
- The QOF regulations prohibit investments in a QOF by a related party if the taxpayer is attempting to defer gains by selling to or buying from the related party.
In both cases, the definition of a related party is designed to ensure that transactions are conducted at fair market value and that the benefits of tax deferral are not abused through manipulative transactions between closely connected individuals or entities.