Related Party Exchange Rules Explained

Exchanges between related parties are permitted under Section 1031, but they come with an additional requirement that does not apply to exchanges between unrelated parties. Related parties include family members such as siblings, spouses, ancestors, and descendants, as well as entities in which the investor holds more than fifty percent ownership.

When an investor exchanges property directly with a related party, both the investor and the related party must hold their respective properties for at least two years after the exchange. If either party disposes of their property before the two year holding period ends, the tax deferral is retroactively disallowed, and the gain that was originally deferred becomes taxable in the year of the early disposition.

There are limited exceptions to the two year holding requirement. The rule does not apply if the disposition happens because of the death of either party, an involuntary conversion such as a casualty loss or condemnation, or if the investor can establish that neither the exchange nor the early disposition had tax avoidance as a principal purpose. This last exception is narrow and difficult to establish without clear supporting facts.

A separate and often misunderstood issue arises when an investor sells to an unrelated buyer through a qualified intermediary and then uses the proceeds to buy replacement property from a related party. Depending on the facts, the Internal Revenue Service has challenged these structures as an indirect way for the related party to cash out while the investor obtains a stepped up basis, effectively bypassing the two year holding rule. Investors considering any transaction involving a related party on either side of the exchange should have the structure reviewed carefully before proceeding.