Everything's Relative ...except in 1031 exchanges

One of the trickiest rules to figure when structuring a 1031 exchange is the rule involving exchanges between related parties. Can you defer capital gain taxes with an exchange if you sell a property you own to a relative? What if you sell your property to a third party but buy your replacement property from a relative? What if you and a relative wish to swap properties? The answer to all these questions is .....sometimes. The reason for that cop-out answer is because the IRS is a little unclear about when it will and will not allow a related party exchange.

So, what is a related party? In IRS terms, a related party includes certain blood relatives (like siblings and children), spouses, and business entities you may own, like corporations or partnerships.

Why does the IRS care about related parties doing exchanges? Because for years, clever taxpayers did a lot of what the IRS calls "basis shifting." Basis shifting occurs when you want to sell a property with a lot of taxable capital gain. Instead of just selling it and paying the taxes, you could use a 1031 exchange to transfer the gain (or in accounting terms, shift the tax basis) to another property you own under a different name, and then sell the formerly high-gain property in your other name without having to pay the taxes.

The IRS has issued several rulings in recent years that make it clear it intends to prevent basis shifting, starting in 1989 when section 1031 was amended to provide that related parties could exchange properties, so long as each party holds the property they end up with for at least two years after the exchange.

But if you're like 99% of our clients, your encounter with a related party exchange involves a relative on only one 'side' of the exchange: you are either looking to sell your property to a relative, or acquire your new property from a relative, but not both. In this case, the rules are a lot more complicated. From a series of IRS rulings since 1997, the best summary of those rules is this: you can swap properties with a related party if both of you hold your new properties for two years after the exchange. You can sell your property to a relative and exchange into a property from a third party if you and the relative abide by the two year holding period. You may not sell your old property to a third party and exchange into a new property sold to you by a relative...unless that relative is also doing an exchange. And the IRS can still disallow your exchange if it thinks that your exchange was done with basis shifting as an objective.

So after a lot of permutations, the best way to state the rule is back to what we said back in 1997: if the buyer and seller are related, and one of the parties ends up with the property and the other ends up with the cash, the exchange will be disallowed. But be warned: there is still a lot of uncertainty and confusion about related party rules, so don't attempt this kind of exchange without advice from a Qualified Intermediary that really understands the current status of the law about related party exchanges.