Guides

Related Party 1031 Exchange Rules

Exchanges between related parties are generally permitted under Section 1031, but Section 1031(f) generally imposes a two year holding requirement designed to prevent related parties from using an exchange to shift basis without a meaningful change in ownership. A related party is generally defined by reference to Section 267(b) and Section 707(b), and it generally includes family members such as siblings, spouses, ancestors, and descendants, along with entities in which the taxpayer generally holds more than fifty percent ownership, so a San Diego, CA investor exchanging property with a parent, adult child, or a corporation or partnership they control is generally subject to these rules. Under the two year rule, if either party to the related exchange generally disposes of the property received in the exchange within two years of the transfer date, the original deferred gain is generally recognized retroactively as of the date of the original exchange, which can generally create an unexpected tax bill well after the transaction closed. This means a San Diego, CA investor who exchanges an inland rental property with a sibling and then sells the newly acquired property fourteen months later can generally trigger recognition of gain that both parties believed was deferred. Several exceptions generally exist to the two year rule, including dispositions caused by the death of either party, dispositions in a compulsory or involuntary conversion such as eminent domain, and transactions where the taxpayer can generally establish to the satisfaction of the IRS that neither the exchange nor the subsequent disposition had tax avoidance as a principal purpose. This last exception generally requires facts and documentation showing a legitimate non-tax business reason for the timing, and it is generally evaluated case by case rather than through a predictable formula. A related party issue can also generally arise indirectly, such as when a taxpayer exchanges into property acquired from a related party who is treated as a seller, sometimes called related party cash out structures, which the IRS has generally scrutinized closely in past guidance and litigation. San Diego, CA investors considering any exchange involving family members, family trusts, or commonly controlled entities should generally flag the relationship early so the exchange can be structured with the two year rule in mind, and should generally plan to hold the exchanged property for at least two years unless a clear qualifying exception applies. Because the related party rules intersect closely with California's ordinary income tax treatment of recognized gain, an unexpected retroactive recognition can generally be more costly for San Diego, CA taxpayers than for investors in states without an income tax. San Diego, CA families that hold real estate across multiple generations sometimes consider a related party exchange as part of broader estate or succession planning, and while this can generally be a legitimate reason for the transaction, we generally recommend documenting the business purpose contemporaneously, rather than after the fact, since the IRS generally evaluates intent based on the facts available at the time of the exchange. Coordinating a related party exchange with an estate planning attorney in addition to a Qualified Intermediary and tax advisor is generally a prudent step for San Diego, CA families structuring these transactions. Educational content only. This is not tax, legal, or investment advice, and any exchange involving a related party should generally be reviewed with a qualified tax advisor before the transaction is structured.