Related Party Exchanges

A 1031 exchange with related parties is one of the most complex scenarios under Section 1031 of the Internal Revenue Code.
While these exchanges can allow for significant tax deferral benefits, these investment property exchange services are closely monitored by the Internal Revenue Service (IRS) due to the potential for abuse.
Related party rules exist to prevent taxpayers from using family members or controlled companies to shift ownership around while avoiding recognition of taxable gains.
Understanding these rules is essential for investors who are considering selling or acquiring property from a family member or a business entity they control.

What Is a Related Party?

The IRS defines a related party broadly under Sections 267(b) and 707(b) of the tax code. The definition is designed to capture a wide range of family and business relationships where conflicts of interest or coordinated transactions may exist. Related parties include:

• Immediate family members: parents, children, siblings, and spouses.
• Certain in-laws: step-parents, step-children, and other relationships that create indirect ownership overlap.
• Business entities: corporations, partnerships, and trusts with 50% or more common ownership.
• Controlled groups: entities owned or controlled by the same group of related individuals.

This definition ensures that taxpayers cannot easily manipulate transactions by moving property among family members or controlled companies simply to avoid taxes.
For example, selling a rental property to a brother, while at the same time acquiring another property through him, would be carefully scrutinized because the IRS wants to ensure there is a genuine investment purpose behind the deal.

The Two-Year Holding Rule

One of the cornerstones of a 1031 exchange with a related party is the two-year holding rule.
To qualify for tax deferral, both the taxpayer and the related party must hold onto their respective properties for at least two years after the exchange.
If either party disposes of the property before this period ends, the IRS will retroactively disallow the exchange and impose taxes.

This rule applies regardless of whether the property was sold at fair market value.
The IRS is not only concerned about whether the transaction looks legitimate on the surface — it wants to ensure that neither side is using the exchange to accomplish short-term tax avoidance.
Without this rule, two relatives could swap properties, sell them immediately, and both walk away with deferred gains that should have been taxable.

Exceptions to the Rule

There are a few limited exceptions where the two-year rule does not apply. These include:

• Involuntary conversions: If the property is destroyed, condemned, or otherwise lost and replaced using insurance proceeds, the IRS may waive the rule.
• Death of the taxpayer or related party: If one of the parties passes away during the two-year holding period, the rule will not be enforced.

These exceptions recognize that some events are beyond the control of the taxpayer. However, outside these rare circumstances, the IRS enforces the rule very strictly.

Practical Scenarios

Consider an investor who sells a $1 million apartment building to his sister in a 1031 exchange and acquires a $1 million retail property in return.
If the sister sells the apartment building after 12 months, the IRS will disallow the exchange, and the original investor will owe taxes immediately.

Another example: A taxpayer sells a rental property to a corporation in which he owns 75% of the shares and then uses the proceeds to purchase a new property.
Because the corporation is a related party, it must hold the property for at least two years. If it sells within that time, the exchange fails.

These examples demonstrate how easy it is to unintentionally trigger disqualification if the related party has different plans or circumstances change.

Best Practices for a 1031 Exchange with Related Properties

• Work with experienced professionals: A qualified intermediary who has handled related-party transactions before will help ensure the deal is properly documented and compliant.
• Document investment intent: Keep leases, rental agreements, and business records to prove the property is genuinely held for investment.
• Avoid side deals: Any informal agreement to resell or transfer property within two years can disqualify the exchange.
• Plan for the long term: Both parties should commit to holding their respective properties for at least two years.
• Consult tax advisors early: Related party exchanges are too complex to handle without professional guidance.

Common Mistakes to Avoid

• Assuming family transactions automatically qualify: Just because property is exchanged within a family does not mean it is approved by the IRS.
• Selling too soon: Disposing of property within the two-year period is the fastest way to trigger disqualification.
• Forgetting about entities: Many taxpayers forget that corporations, LLCs, and trusts they control are considered related parties.
• Not planning for contingencies: If the related party later decides to sell early, the original taxpayer will still face consequences.