Understanding Related Party Transactions in 1031 Exchanges

When conducting a 1031 exchange, it’s common for one or more parties involved to be considered a “related party.” The IRS defines related parties broadly, including direct family members (such as parents, children, spouses, and ancestors), as well as parties connected through trusts, corporations, partnerships, or other entities that ultimately link back to the taxpayer.

Because related party transactions are closely scrutinized by the IRS, it’s essential to proceed with a clear understanding of what is involved, what is acceptable, and what is not (you can always call us with any questions at +1 619 923 1031). The IRS devotes a significant portion of Form 8824 (the form used to report 1031 exchanges) to questions about related party involvement. This highlights how seriously the IRS monitors these transactions and the potential for disqualification if the rules are not followed.

Always consult with your tax advisor and a qualified intermediary before initiating any 1031 exchange involving related parties. Failing to do so can result in a rejected exchange, leading to taxes, penalties, and interest for both parties.

Types of Related Party Transactions in 1031 Exchanges

Let’s break down the two main scenarios involving related parties in a 1031 exchange:

1. Selling a Relinquished Property to a Related Party

• The taxpayer sells their investment property (the relinquished property) to a related party.

• The taxpayer then acquires a replacement property from an unrelated party.

• In this scenario, no basis shifting occurs, making the transaction generally acceptable under 1031 rules.

• The related party who acquires the relinquished property has no holding period requirements and can use the property for personal, investment, or business purposes.

2. Purchasing a Replacement Property from a Related Party

• The taxpayer sells their relinquished property to any party and acquires a replacement property from a related party.

• If the related party selling the replacement property does not also perform a 1031 exchange (or does not qualify for one), the transaction is typically not allowed.

• This restriction exists because the IRS wants to prevent “basis shifting,” which could allow taxpayers to cash out without paying taxes.

• However, if the related party also completes a 1031 exchange and acquires their own replacement property from an unrelated party, the transaction may be permitted.

• In these cases, both parties must hold their new properties for at least 24 months. If either party fails to meet this holding period (except in the event of the taxpayer’s death), both exchanges can be disqualified.

• Any cash received by the related party during the exchange or within the following two years could trigger tax liabilities for both parties if it causes the exchanges to fail.

Due to the complexity and risks involved, related party exchanges require careful planning and professional guidance.

Key Takeaways

• The IRS pays close attention to related party transactions in 1031 exchanges.

• Selling to a related party is generally allowed if the replacement property is purchased from an unrelated party.

• Buying a replacement property from a related party is only allowed if the related party also completes a qualifying 1031 exchange and both parties hold their new properties for at least 24 months.

• Always consult your CPA, tax advisor, and qualified intermediary before proceeding with a related party 1031 exchange to ensure compliance and achieve your financial goals.

In conclusion, it is essential to discuss with your CPA/Tax Advisor and Qualified Intermediary before proceeding with a 1031 Exchange transaction involving related parties. This conversation will help clarify whether the transaction goals can be achieved and if it meets the criteria under IRC Section 1031.

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