Current Related Party Rules for 1031 Exchanges

Section 1031 law does not allow you to sell a property to, or buy a property from, a related party if your motive is tax avoidance. But the basic rule is so vague and ambiguous that it leads to a lot of calls from clients and inquiring potential clients wondering what they can or cannot do when the parties are related. 

First, let's define what a related party is; who is "related" to you?

The code defines a related party as someone that is closely related to you by blood: your parents, grandparents, kids and grand kids. It also includes your brothers and sisters, and of course, your spouse. Nieces, nephews, aunts and uncles, to name a few are, for our purposes, not related to you. 

Corporations, partnerships and LLCs (limited liability corporations) are also "related" to you if the entity is owned primarily by a related person or persons. "Primarily" in this case typically means that a related person owns more than 50% of the entity. For example, if you are selling a rental property to an LLC that is owned by your father, that would violate the related party rules. But if your father only owns 33% of the LLC, and two of his buddies (who are not related to you) own the other 67%, the LLC is not considered a related party and your sale and exchange are OK. 

When discussing this rule with a client, a common question she may ask is, "since my father's name is different from my married name, how will the IRS know we are related?" The answer is they probably won't. But one of the questions on Form 8824 (the IRS form she'll use to report her exchange) asks if her exchange is with a related party. If she answers "no" and the IRS finds out that she in fact sold the property to her dad, she's in major trouble. So don't play games with this rule. 

The law also says that the transaction with the related party cannot be primarily for tax avoidance. Here's where things really start to get murky. What is tax avoidance? No one knows since the IRS hasn't given us any examples. What we do know is that they've refused to rule on such simple, common questions as "will buying my parent's house violate the related party rules if their gain is all tax-free because it's the sale of their primary residence?" or "my son's a builder--can I buy one of his spec houses to use as a rental if I buy it for the same price he listed to the public, and he pays tax on the gain?" It's troubling that the IRS won't rule on questions like these; it seems so logical to you and I. But the rule of thumb they've adopted is simply that if a property is sold at a gain, and at the end of the transaction the gain is deferred by Section 1031, and the cash and a related property remain within the family unit, the transaction will violate the tax avoidance intent of the law. 

An easy out that will avoid this problem is to have the related party also do a 1031 exchange. For example, if you sell a rental and buy an office building owned by your father, the transaction will violate Section 1031 unless your father also does a 1031 exchange on his sale. Assuming that he does an exchange, your gain will be deferred, your dad's property will remain within the family, but since the cash doesn't (because your dad did an exchange), the transaction will not violate the related party rules. Be careful though: if you do an exchange in this situation based on the expectation that your dad is also doing an exchange, and if his purchase falls through, your exchange is retroactively toast and your gain is taxable. 

And that brings us to the final requirement of a related party exchange: the related property has to remain within the family for two years following the exchange. Otherwise the original exchange is retroactively toast. In the above example, you'd want to make sure you held your dad's office building for two full years after your exchange. 

If you have options, it's best to avoid this situation altogether and buy from or sell to an unrelated party. BUT: if a 1031 exchange with a related party is your only possible scenario, call us and let us help sort the details. Finding the best 1031 solution to your situation isn't your job; it's ours.