Can You Do a 1031 Exchange With a Family Member?

The general idea behind a 1031 exchange is to defer taxes when you reinvest the proceeds from the sale of your real property into a like-kind asset. However, when the other party you’re dealing with is your family member, the Internal Revenue Service (IRS) becomes cautious because it presents a good opportunity for tax abuse.

So yes, you can do a 1031 exchange with a family member, but under strict conditions and IRS scrutiny. In fact, the interpretations of the conditions are so complex that you stand a higher chance of getting disqualified than being successful. Your best bet to hit a home run will be to rely on the experience of a renowned Qualified Intermediary and tax advisor.

Universal Pacific 1031 Exchange is not just the most reputable provider of Qualified Intermediary services in Los Angeles, but also home to several Certified Public Accountants (CPAs). We help our clients navigate complicated 1031 exchange situations while providing all the essential tax and financial advice for successful transactions. Book a free consultation with our experts today so we can help you start an exchange.

This blog answers the essential questions on the execution of 1031 exchanges with related parties. It also explores the rules guiding these exchanges and the best practices to adhere to.

Can You Do a 1031 Exchange With a Family Member?

Yes, the IRS allows taxpayers to conduct 1031 exchanges with their family members. The tax law calls this an “exchange between related persons.” Due to the likelihood of people abusing the system and using it as a strategy to avoid tax outside the provisions of the law, the Internal Revenue Code (IRC) outlines strict restrictions on how such exchanges can be conducted. 

Who Qualifies as a Family Member in a 1031 Exchange?

According to Section 267(c)(4) of the IRC, family members of a taxpayer include their spouse, siblings, ancestors, and lineal descendants. Ancestors include parents, grandparents, great-grandparents, and the rest. On the other hand, lineal generations encompass children, grandchildren, great-grandchildren, and their descendants. 

Siblings refer to your brothers and sisters, irrespective of whether you share the same parents or one parent. The related-party clause of Section 1031(f) kicks in once you’re doing a 1031 exchange involving any of these persons. Apart from family members, other related parties are a trust in which you are the grantor and companies or corporations where you hold more than 50% of the capital interest.

The law does not include ex-spouses and in-laws. However, you must exercise caution and consult a tax expert before running an exchange with them.

IRS Rules on Related-Party 1031 Exchanges

The 1031 exchange rules for related parties, such as immediate family members, are quite complicated and depend on whether you’re swapping, buying, or selling to a related party. However, all these are binding to the two-year holding period rule. We’ll explain this rule before exploring the peculiarities of the three aforementioned scenarios.

Two-Year Holding Period

The tax law requires you and the related party to observe a two-year holding period before and after the exchange transaction. This rule exists mainly to prevent quick flipping and tax basis manipulations. 

So, you can only exchange a property held for two or more years. Similarly, neither you nor the other party is allowed to dispose of the replacement property acquired until two years after the transaction.

Since they are investment properties, you and the related party must use your respective assets for business purposes during this period. If they are rental real properties, both parties must collect rent as proof that the assets are not for personal use.

Swapping Properties With a Related Party

You can conduct a direct swap with a family member and enjoy the nonrecognition treatment. This is known as a two-way related party exchange or a mutual exchange. It means you’re selling your relinquished property to the related party and buying a replacement property from them.

You can do this with or without a Qualified Intermediary. A QI will not be necessary if the swap is simultaneous. But you must hire one if it’s a delayed or reverse exchange. Nonetheless, it’s advisable to always work with a QI because two-way related party exchanges have several grounds for disqualification. 

For instance, the IRS will investigate the transaction to determine if there is an intentional or unintentional basis shift that could lead to potential tax evasion. So you need a 1031 exchange tax professional who will guide you accordingly to avoid losing your capital gains tax deferral status.

Selling to a Related Party

The IRS doesn’t have issues with this scenario since it doesn’t leave cash in your hands or that of the family member. All the proceeds from the sale go into acquiring the like-kind replacement property. So long as you observe the two-year rule, you’re good to go.

Buying From a Related Party

This scenario attracts as much IRS scrutiny as the mutual exchange because it puts cash into the hands of the related party. The IRS arbitrarily considers it an avenue for a deliberate act of income tax basis swap and may move to disqualify the transaction, making you unable to defer income tax liabilities.

However, there are two strategies for buying a replacement property from a related party that will not attract immediate tax pitfalls. The first is that the related party must conduct its own 1031 exchange.

This means they must hire a Qualified Intermediary before selling their property to you. Upon receiving cash through their QI, the related party must buy a replacement property of equal or greater value. That way, the IRS will consider it a legitimate deal devoid of tax-basis shifting motives.

The second strategy is to sell your relinquished property to an unrelated party via a 1031 exchange and wait out the holding period before initiating another 1031 exchange with the family member. You should only do this if you really want to buy the property from your related party at all costs.

The IRS waives the related party restrictions in 1031 exchanges when you’re buying a real estate asset from an immediate family member using another property you acquired at least two years ago through a previous 1031 exchange. 

In this scenario, the related party is not required to conduct their separate 1031 exchange. Waiting out two years gives the IRS reasons to accept that you’re dealing in good faith and not for tax avoidance. 

Notwithstanding, you can increase your odds of success by ensuring that the taxable gain the related party makes from the transaction exceeds your deferred taxable gain from the sale of your relinquished property.

Exceptions to the Two-Year Rule

The first exception is an instance where one of the two parties dies before the expiration of the holding period. In that case, their property may be disposed of without affecting the capital gains tax-deferred status of the transaction.

The second exception applies if any party disposes of their property involuntarily due to circumstances beyond their control, such as a natural disaster. The last ground for an exception is if the Secretary of the Treasury of the United States is convinced enough that neither of the two related parties entered the deal with the aim of evading taxes.

Any transaction that defies the two-year rule and is not justified under the exceptions is liable to immediate taxes payable in the same tax year as the deal. Notwithstanding, every related party 1031 exchange must be filed with the IRS using Form 8824.

When Can You Do a 1031 Exchange with a Family Member?

The only time you should do a 1031 exchange with a family member is when you really need the property the person owns. You must also be sure that both of you are committed to not disposing of your respective replacement properties for at least two years after the deal. 

Make sure to hire the services of an experienced QI—even if it’s a mutual exchange—to help you support the IRS compliance of the deal. Transactions structured for tax avoidance or tax basis swapping are not allowed. If culpable, the IRS will invoke the step transaction doctrine to disqualify your transaction.

Best Practices for Exchanging Property with a Family Member

These are helpful tips you should bear in mind to conduct successful exchange transactions with a related party:

• Plan for Long-Term Holding: We can’t say this enough; any plan to use a related party 1031 exchange as a means for scooping quick cash is dead on arrival. You must be ready to hold the properties concerned for at least two years before and after the transaction—as it applies.
• Work With a Qualified Intermediary: Apart from being compulsory in all forms of 1031 exchanges—except a simultaneous transaction—working with a QI will significantly reduce your chances of creating taxable events.
• Keep Detailed Documentation: The proof that you played by the book will be seen in the documents you’ll provide to the IRS during their investigations. So, make sure to keep every document, including receipts and agreements, that will help you prove your argument and intent.
• Consult a Tax or Financial Advisor Experienced in Related-Party Transactions: Reputable firms like Universal Pacific 1031 Exchange have CPAs who can give you all the tax advice you need for a successful exchange. They also have sufficient resources to help you see your case through in the face of any IRS scrutiny.
• Avoid Receiving Cash or Boot During: When you or the related party receives cash from the transaction, the IRS will certainly have reasons to doubt the transaction’s legitimacy. As much as possible, try to avoid conducting a related party transaction that involves cash.

Other Options When You Can’t Exchange With a Relative

If you’ve consulted with your tax advisor and the peculiarities of your situation make it impossible to legitimately run the exchange without exposing yourself to tax liabilities, you should consider any of the following 1031 exchange alternatives:

1. Delayed Exchanges: This is the most common type of 1031 exchange with unrelated parties. It involves disposing of your relinquished property and buying a new one within 180 days. You’re also required to identify the potential replacement property within the first 45 days of the sale.

2. Reverse Exchange: You can use the reverse exchange strategy if you have reasons to buy the replacement property before relinquishing your current asset. The success of this exchange depends on your QI’s ability to carefully structure the transaction using an Exchange Accommodation Titleholder.

3. Partnership or LLC Arrangements: You can use your company or partnership to facilitate a like-kind exchange. Similarly, you can buy investment properties from another LLC in a 1031 exchange while maintaining your tax-deferred status.

4. Gift the Related Party a Property: If you’re bent on transferring ownership of your property to a related party, you may consider sending it to them as a gift. But consult a tax advisor before taking this route, as real estate gift transfers have tax implications.

Want a Smooth and IRS-Compliant 1031 Exchange with Family?

As we’ve discussed, it’s possible to run an IRS-compliant exchange involving family members. All it takes is a proper understanding and interpretation of the rules guiding it. Due to its complexity, you need to ensure that your Qualified Intermediary is a seasoned professional with the requisite expertise and resources to help you navigate the nitty-gritty of the transaction.

That’s why you should work with Universal Pacific 1031 Exchange. We have various in-house tax and financial professionals dedicated to helping you run successful related party transactions—irrespective of how complicated it may look—and deferring taxes on capital gains.

And if we have reasons to believe that the deal won’t pull through due to the situation’s peculiarities, we’d be the first to let you know with facts and proof you can trust. Walk into our 1031 exchange office or book a free consultation with us now so we can analyze your exchange potential before you start the exchange.

Frequently Asked Questions (FAQ)

What Happens If My Family Member Sells the Property Within Two Years?

Your recognized gain will be subject to immediate tax payment if your family member sells the property within two years.

Can I Exchange My Rental Property With a Family Member’s Vacation Home?

No, you cannot. One of the rules of 1031 exchanges is that only property held for investment or business purposes is qualified to be exchanged. A family’s vacation home is used for personal purposes only. To become eligible, the property must be converted to commercial use, and the related party must collect rental income from the occupants for at least two years before the transaction.

Are 1031 Exchanges Between Spouses Allowed?

Yes, exchanges between spouses are allowed as long as they meet the stringent IRS rules discussed in this article.

What Are the Penalties for Violating 1031 Family Member Rules?

The penalty is immediate tax payment. You can no longer defer income tax liability from the sale of the property concerned.

Will the IRS Audit a Family Member 1031 Exchange?

Yes, the IRS can audit a family member 1031 exchange if they have reasons to believe that the parties are using the transaction to avoid tax outside of the provisions of Section 1031 of the IRC.