When is a 1031 Exchange with a Related Party Allowed?

by Maura Snabes, Esq., CES, NTP

November 2024

Occasionally, a taxpayer contemplating a 1031 exchange wants to convey real property to or acquire real property from a related party. But is this allowed under Section 1031 of the IRC? Well, that depends.

In 1989, the IRS tightened up its allowance of related party exchanges, due to such exchanges being done for the primary purpose of “basis shifting”. This involves property that has a low tax cost basis (and therefore a large capital gain) for property owned by a related party that has a high tax cost basis (and therefore a small capital gain) in order to reduce or eliminate the overall taxes paid by the related parties.

And, although the intent of the taxpayer is a factor at which the IRS looks when auditing a 1031 exchange, whether a related party exchange is successful depends primarily on whether the taxpayer is selling to a related party only, swapping with a related party, or acquiring from a related party.

A “related party” is defined in IRC Sec. 267(b) and 707(b)(1). Related party includes ancestors, lineal descendants, siblings, spouse and entities of which the taxpayer owns more than 50% (directly or indirectly). For example, if a taxpayer owns a 25% membership interest in an LLC and the taxpayer’s brother owns 50%, the LLC is related to the taxpayer—the taxpayer owns 25% directly and 50% indirectly.

Who is not a related party: In-laws, aunts, uncles, cousins, and ex-spouses. Be cautious in community property states where a spouse will have a community property interest in the replacement property. In those cases, receipt of real property from in-laws will be a related party transaction.

When is a related party exchange allowed?

There are some circumstances in which a related party exchange will be allowed:

1. Related party swap and 2-year holding period. 1031(f) requires both related parties hold on to replacement property received in an exchange for at least 2 years in a swap situation, to prevent basis shifting. If either party transfers their property before that date (with some exceptions) both exchanges will be disqualified, with both taxpayers obligated to pay tax on their gain.

2. Taxpayer acquires RP from related party and related party is doing its own 1031 exchange and not cashing out. Receipt of cash is one of the considerations for the IRS in disqualifying an exchange. Revenue Ruling 2002-83 clearly states that tax deferral is not permitted if the related party receives cash or debt relief. If they do, Revenue Ruling 2002-83 is violated and exchange will be disallowed.
   
   
3. Selling to related party and buying from unrelated party. This scenario is generally considered to be fine, based on many Private Letter Rulings. The theory is that since the taxpayer is shifting its low basis to a property owned by an unrelated party, there is no cashing out of their investment. However, a taxpayer should always check with its tax advisor.

Thinking of doing a 1031 with a related party that doesn’t quite fit into any of these scenarios? Be sure to check with your tax advisor. Remember that IRS Form 8824 must be filed when a 1031 Exchange involving like-kind property occurs. When related parties exchange property, it must be indicated on the form and additional information is required, including the name and relationship of the related party.