When it comes to the 1031 exchange world, there are extra rules that come into play when you’re considering an exchange with any party or entity that’s related to you. Certain restrictions here might prevent these exchanges altogether in some cases, and in others, they may require a replacement property to be held for a two-year 1031 exchange holding period.
At 1031 Exchange Place, we can help you navigate the rules for exchanging property with a related party. Here are some basics to know in what will be a two-part educational blog.
Related Party Exchange Basics
Firstly, let’s define a related party exchange: When any taxpayer performs a 1031 exchange with any party or entity that’s considered related under the US tax code. This includes spouses, siblings, ancestors, and direct lineal descendants, per Sections 267(b) and 707(b) of the Internal Revenue Code, but it also includes any corporation or partnership in which you own at least 50 percent interest. Check both sections above to confirm whether you’re considered related, as there are several possible unique situations they cover.
For many years, it was possible to complete a related party exchange without any restrictions. However, in 1989, the IRC was changed as part of an effort to rid “basis shifting” from the industry, a practice where people traded low-basis properties with high-basis ones using a relation, eliminating or heavily reducing capital gains taxes on the low-basis property.
So Can I Exchange?
Well, it depends on what you’re trying to do in the exchange. Our next section and our follow-up blog will focus on the kind of exchange you’re looking for and restrictions or exceptions that might play a role.
Related Party Swaps
In cases where you are relinquishing your property to a related party, then acquiring your replacement property from that same related party, these kinds of swaps will be allowed – as long as both sides of the exchange hold their acquired properties for at least two years after the final exchange transfer. Your exchange will be immediately disqualified if either party transfers the property before this, requiring both of you to pay taxes on any gains.
Related Party Sales
Much of the discussion when doing an exchange where you sell to your related party involves the use of an intermediary. Both court rulings and the IRS code maintain that using intermediaries does not remove any restrictions on these exchanges, however – this used to be an avenue some folks explored to try and avoid such restrictions.
That doesn’t mean you can’t perform this kind of exchange at all, however. Like with swaps, it’s generally recommended that both you and your related party hold your new property for at least two years, though there are exceptions here that we’ll discuss below. There are often situations where this two-year restriction can be avoided.
Related Party Purchases
Most of the time, courts or the IRS do not allow exchanges where you buy from a related party, then sell to an unrelated one using an intermediary. This is due to basis shifting, which we discussed in part one of this blog. There are still very limited situations where you can perform such an exchange, though, such as if the related party is also performing an exchange with their own unrelated party.
Various Exceptions
There are several exceptions to the areas we’ve discussed in this series:
- Death: Parties are allowed to dispose of properties before the end of the two-year holding period if either the taxpayer or related party dies during this period.
- Involuntary conversion: If either property is subject to this during the two-year holding period, the parties will not be taxed.
- Not for avoidance: If it can be established that your primary purpose is not to avoid Federal income tax, trading with related parties will be allowed. This is also called the non-tax avoidance exception,” which our advisors can explain in more detail.
For more on related party exchanges, or to learn about any of our 1031 exchange properties or services, speak to an advisor at 1031 Exchange Place today.