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1031 Exchange Rules for Related Parties

October 6, 2023

1031 exchanges between related parties come with special rules from the Internal Revenue Code (IRC). The IRS stipulated these guidelines to ensure fairness, prevent tax deferral abuse, and facilitate legitimate, tax-efficient property swaps. You need to understand every detail of these related party rules while handling a related party exchange to enjoy tax benefits and avoid any financial missteps.

In this guide, we’ll explore everything you need to know about 1031 exchanges with related parties, the IRS rules guiding them, common mistakes to avoid, and more.

A Brief Overview of 1031 Exchanges For Related Parties

A Brief Overview of 1031 Exchanges For Related Parties

When related parties are involved in a tax-deferred exchange, there’s a higher risk that the exchange might be structured to manipulate the tax code for personal gain. For example, two family members could agree to exchange properties at inflated values to minimize their taxable gains, even if the properties are not actually worth the stated values.

Related parties may also engage in basis swapping – a strategy where investors swap properties with significantly different fair market values and adjusted bases. The IRS closely monitors these related party 1031 exchange transactions because of their potential to be used to “swap” the basis of low-value properties with high-value ones, thereby attempting to evade due taxes.

To prevent possible tax abuse, the IRS has implemented additional regulations to ensure that 1031 exchanges involving related persons are conducted in a manner consistent with the intended purpose of the tax code. Hence, taxpayers considering a related party exchange may need to consult with tax professionals or 1031 exchange experts to ensure they comply with IRS regulations and avoid potential pitfalls.

Types of 1031 Exchanges

Types of 1031 Exchanges

 

Like-Kind Property Exchange

The traditional 1031 exchange is also known as like-kind exchange. It involves exchanging a relinquished property for a replacement property of a similar “kind” while postponing capital gains taxes. In this context, like-kind does not apply only to identical properties but extends to properties with a similar nature or character, even if they vary in grade or quality. For example, you can exchange vacant land for a rental apartment as long as both properties are held for investment or business purposes.

Delayed Exchange

In some cases, you can sell the relinquished property before purchasing a replacement property. This method is known as delayed exchange. Although it seems straightforward, you must adhere to the rigid timelines stipulated by the IRS to maintain the tax-deferred status. You’ll have to identify a replacement property within 45 days and secure the property within 180 days.

Reverse Exchange

Instead of selling the relinquished property first, you can acquire the replacement property before selling the old one. So, basically, a reverse exchange, also known as a parking exchange, reverses the order of the transaction. This method offers the advantage of acquiring a promising investment property without immediate selling pressure, but you must also abide by the reverse exchange rules to make it successful.

Improvement or Construction Exchange

Here, investors can use their equity from the relinquished property to improve or construct on the replacement property. However, it requires that the investor must finalize any construction or improvement and transfer the property within the 180-day deadline. Also, they must spend the full value of the exchange on improvements or as part of the property’s purchase price.

Who Qualifies as a Related Party?

Who Qualifies as a Related Party?

To ensure compliance and avoid tax consequences, you need to understand who “related parties” are as defined by the IRS. According to Section 267(b) of the Internal Revenue Code, related parties in a 1031 exchange include people who are connected to the taxpayer in the following ways.

  • Family: siblings, spouses, parents, grandparents, children, grandchildren, etc. However, note that spouses of those individuals, like your brother’s wife or your son’s wife, do not count as related in this context.
  • Business: a person and a corporation where the taxpayer directly or indirectly owns more than 50% in value of the outstanding stock.

The 50% Ownership Rule

Digging a bit deeper into business relationships, the Internal Revenue Service stipulates that anyone with more than 50% ownership, directly or indirectly, in a corporation or partnership is considered related. The indirect ownership part can be a bit tricky. It means if you own a business that in turn owns another business, your ownership in the second business also counts when adding up to the 50%.

What are the 1031 Exchange Rules for Related Parties?

What are the 1031 Exchange Rules for Related Parties?

Following the specified 1031 exchange rules, related parties are expected to ensure that their tax deferred exchanges serve its original purpose of investment continuity rather than a strategy for evading tax. The laws to watch out for in this context include the following:

IRC Section 1031

To ensure compliant tax deferred exchange, the Internal Revenue Code (IRC) Section 1031 stipulates the fundamental rules for all types of like-kind exchanges. However, the rules become more complex when the exchange involves related parties. Hence, investors need to pay extra attention to the related party rules to stay compliant.

The Two-Year Holding Rule

The Two-Year Holding Rule requires that in a related party 1031 exchange, both the old and new properties must be held for at least two years after the exchange. This prevents related parties from quickly selling properties to avoid paying taxes, making sure the tax benefit is used correctly.

Consequences of failing the two-year holding rule

If either party disposes of the property within the two-year window, the deferred tax benefits are reversed. The initial seller in the exchange, even if they adhered to all rules, becomes liable for income tax if the related party fails to adhere to the two-year holding period.

Key Subsections Related to Related Parties

Subsection 1031(f): This subsection emphasizes the two-year rule holding rule regarding related party exchanges. It stipulates that both the exchanger and the related party must hold their respective properties for a minimum of two years after the exchange to fully benefit from tax deferment.

Section 267: While Section 1031 primarily focuses on related parties within the context of like-kind exchanges, Section 267 has a broader application, encompassing various types of transactions and related party relationships. It’s recommended to carefully consider Section 267 to ensure compliance with 1031 exchange related party rules, as non-compliance can have tax implications beyond the immediate exchange.

Other Relevant Laws and Regulations

Other Relevant Laws and Regulations

There are several other laws and regulations that can affect related-party transactions in 1031 exchanges apart from the Internal Revenue Code. Some of them include:

The Economic Substance Doctrine 

According to the Economic Substance Doctrine, the Internal Revenue Service requires that a transaction has a substantial business purpose beyond just deferring tax or savings to qualify for tax benefits. So, it’s crucial to ensure that related-party exchanges have legitimate business purposes to avoid scrutiny from the IRS.

State Laws

Different states in the US may have internal regulations regarding related parties, different from federal laws. So, it’s important to study your local laws to ensure compliance in case of these differences.

IRS Guidelines

The IRS also provides guidance on related-party transactions in its publications and notices. You should ensure to stay current with IRS updates and if you have questions regarding any related party rules, you can book a free consultation with our 1031 exchange professionals at Unified Pacific 1031 Exchange for expert guidance.

Benefits of 1031 Exchanges for Related Parties

Tax Deferral

Deferring capital gains taxes means more capital for investment. When related parties are involved, it can strengthen their financial position by keeping more money within their network. 

Asset Diversification

With a 1031 exchange, you can swap properties without paying taxes right away. For related parties, this provides an opportunity to diversify into various assets and explore different markets or regions.

Business Growth

By deferring tax and reinvesting into properties that align more with their business strategies, related parties can combine efforts to optimize their investments for business growth while staying compliant.

Pitfalls, Risks and Issues for Related Parties

Despite the appealing benefits, 1031 exchange for related parties involves certain risks every investor should be wary of. Such risks include:

Tax Consequences: You may lose your tax benefits if you default any of the rules guiding related parties property exchange. 

Identification Period Rules: The tight deadlines stipulated for a valid exchange can create pressure and stress. And if you can’t identify or secure a suitable replacement property within the time limit, the exchange could fall through.

Failure of Qualifying for 1031 Exchange: The intended transaction may not even qualify for 1031 exchange benefits if any of the related parties fail to meet any of the IRS requirements.

Transaction Guidelines for Related Parties in a 1031 Exchange

Executing a 1031 exchange involves a series of crucial steps to ensure a smooth and successful transaction. These steps are listed below.

Initiation

  • Finding a Qualified Intermediary: A Qualified Intermediary (QI) helps navigate through the rules and ensures all steps in the 1031 exchange are completed correctly and on time. Choose a Qualified Intermediary who is experienced with a track record of success in 1031 exchange for related parties.
  • Property Identification Rules: From the 180-day timeline to other provisions such as the 200% rule, ensure that you adhere to the IRS regulations governing valid replacement property identification. Our experts at Universal Pacific 1031 Exchange can help guide you through this process.

Execution

  • Handling Exchange Documents: Every document, like the purchase agreement and assignment, must be in place and correctly filled out to proceed with the exchange.
  • Funds Transfer Mechanism: The IRS prohibits the taxpayer from being in custody of the proceeds from the sale of the relinquished property. Instead, the Qualified Intermediary secures the funds in an escrow account and releases it when it’s time to facilitate the purchase of the replacement property.

Closing

  • Document Verification: It’s important to double-check all documents for accuracy and completeness to avoid any post-closure issues. Ensure that all forms, agreements, and legal documents are correct and duly signed.
  • Reporting to the IRS: Lastly, the 1031 exchange must be reported to the IRS using Form 8824 in the year the exchange took place, ensuring that all details of the transaction are transparent and in compliance with tax laws.

Special Exceptions and Exclusions

The IRS recognizes certain special cases or exceptions to the exchange rules. The exceptions include exchanges solely involving:

  • Stock in trade
  • Inventory
  • Stocks
  • Bonds
  • Notes

International Aspects

Related party rules for a 1031 exchange can become more complex when the related parties involved are in different countries. Consider the following aspects.

Foreign Property Qualification: The properties involved in the exchange must meet the IRS’s definition of like-kind property both in the United States and in the foreign country. Hence, the parties need to understand and adhere to the property qualification criteria in both jurisdictions.

Foreign Taxation: Related party exchanges may also be subject to local regulations in the foreign country. For instance, in the United States, the Foreign Investment in Real Property Tax Act (FIRPTA) governs the taxation of foreign investors in U.S. real estate. 

Other countries may have similar rules for foreign investors, and understanding the foreign tax laws and how they interact with U.S. tax rules is essential to avoid double taxation.

Tax Treaties: The United States has tax treaties with many countries that can impact the tax treatment of international transactions in issues such as withholding taxes and the recognition of federal income tax.

Currency Exchange: Fluctuations in currency exchange rates can impact the value of the exchange and the eventual tax liability.

Considering the complexities involved in international exchanges for related parties, it’s essential to involve an experienced Qualified Intermediary for proper guidance and compliance. Our experts at Universal Pacific 1031 Exchange have the required expertise and experience to help you facilitate a smooth and compliant exchange. Book a free consultation with us to get started.

Common Mistakes to Avoid

Incomplete Documentation

A successful 1031 exchange requires proper paperwork. Endeavor to submit essential documents, such as the Exchange Agreement, Assignment, Notice, and Accommodation Agreement, accurately and on time.

Property Not Held for Investment

Misclassifying property usage, even unintentionally, may result in an invalid exchange. Be sure to involve only properties that are held for productive use in business or investment.

Violating the Two-Year Rule

Disposition of the exchanged property within two years, unless under particular circumstances like death or compulsory conversion, invalidates the exchange and makes the transaction liable to tax.

Conclusion

Executing a successful 1031 exchange is all about understanding and complying with the necessary rules and requirements. For exchanges involving related parties, you need to be sure the transactions comply with the additional requirements stipulated by the IRS. These rules may seem complicated, but our experts like Unified Pacific 1031 Exchange have got you covered. Book a free consultation with us for a seamless experience.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.