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A 1031 exchange is a complex process, and related party rules can be particularly tricky to navigate. For example, if you're exchanging a property with a family member or business partner, you'll need to consider the rules around disqualified persons.
Disqualified persons include certain relatives, such as children, spouses, and parents, as well as business partners and certain types of corporations. These individuals are considered related parties and are subject to additional rules and restrictions.
To qualify for a 1031 exchange, the property you're exchanging must be held for investment or business use, and the property you're acquiring must be of like kind. However, related parties may be exempt from this rule in certain situations.
For instance, if a spouse is exchanging a property with their spouse, they may be exempt from the like-kind rule.
Consider reading: 1031 Exchange Business
Who Is a Party?
A related party in the context of a 1031 exchange is defined in I.R.C. § 267(b) or 707(b)(1). This definition generally covers exchanges between family members, including spouses, parents, and siblings.
Immediate family members, such as brothers, sisters, spouses, ancestors, and lineal descendants, are considered related parties. They are not, however, considered related parties if they are stepparents, uncles, aunts, in-laws, cousins, nephews, nieces, or ex-spouses.
Entities that are affiliated or controlled by the same person or group are also considered related parties. This includes a parent corporation and its subsidiaries, as well as a partnership and a person who owns more than half of the partnership.
To determine who owns what, section 267 rules are used. This means that if two partnerships have the same owners, they are considered related parties.
Worth a look: Can a Partnership Do a 1031 Exchange
Party Rules and Exceptions
Related party rules can be complex, but understanding them is crucial for a successful 1031 exchange. The IRS defines a related party as any person or entity with a relationship to the taxpayer described in Section 267(b) or Section 707(b)(1) of the Internal Revenue Code.
A related party includes family members, such as siblings, spouses, ancestors, and lineal descendants. It also includes corporations, limited liability companies, or partnerships where more than 50% of the stock, membership interests, or partnership interests are owned by the taxpayer.
The IRS has specific rules to prevent tax abuse in related party 1031 exchanges. If the relinquished property is sold to a related party, the property must be held for two years before selling or the tax deferred by the 1031 exchange is due.
Related party 1031 exchanges are permitted, but only if the related party is also initiating a 1031 exchange. You can purchase the replacement property from a related party, but you must follow specific rules and requirements issued by the IRS.
To avoid related party issues altogether, you can eliminate the related party relationship prior to structuring and completing the 1031 exchange transaction. This can be done by transferring or disposing of interests in a partnership or shares in a corporation to an unrelated third-party.
Here are some examples of related parties:
- Immediate family members, such as brothers, sisters, spouses, ancestors, and lineal descendants
- Corporations, limited liability companies, or partnerships where more than 50% of the stock, membership interests, or partnership interests are owned by the taxpayer
- Two partnerships in which the same person or persons own more than a 50-percent capital interest or a 50-percent profits interest
- An executor of an estate and the beneficiaries of the estate
Note that some relationships, such as stepparents, uncles, aunts, in-laws, cousins, nephews, nieces, and ex-spouses, are not considered related parties.
Attribution and Transactions
If the old property is sold to a related party, the property must be held for two years before selling or the tax deferred by the 1031 exchange is due.
Related parties can be avoided altogether if the related party relationship is eliminated prior to structuring and completing the 1031 Exchange transaction.
Immediate family members, such as brothers, sisters, spouses, ancestors and lineal descendants, are considered related parties.
Corporations, limited liability companies or partnerships in which more than 50% of the stock, membership interests or partnership interests, or more than 50% of the capital interests or profit interests, is owned by the taxpayer is considered to be a related party.
You can purchase the replacement property from a related party, only if they are also initiating a 1031 exchange.
Rules for Sellers and Buyers
If you're planning a 1031 exchange, you'll want to understand the rules for related sellers and buyers. Related Seller Rules in a 1031 Exchange are strict, and exchanges won't qualify for tax deferral unless the related party seller also does an exchange.
For your interest: Seller Financing 1031 Exchange
Exchanges in which the Replacement Property seller is a related party will be denied if they receive cash or non-like-kind property, regardless of whether the Exchanger holds the Replacement Property for two years. The IRS views this transaction as yielding the same result as if the Exchanger swapped properties with a related party, then sold the property immediately.
To avoid this, related parties can't simply interpose an unrelated Qualified Intermediary. However, the IRS has issued rulings permitting a "daisy chain" of exchanges in which Exchangers acquire Replacement Property from related sellers who also acquired Replacement Property from another related seller.
In these cases, all related parties must hold their respective Replacement Properties for at least two years. A small amount of boot (5% or less) received by any of the related Replacement Property sellers won't destroy all of the other related exchanges.
For related buyers, the IRS has clarified that there is no basis shifting or tax avoidance when the taxpayer transfers Relinquished Property to a related buyer, but acquires Replacement Property from an unrelated seller.
Expand your knowledge: How Many Properties Can You Identify in a 1031 Exchange
Two-Year Rule and Related Topics
The two-year rule is a crucial aspect of the 1031 exchange related party rules, and it's essential to understand its implications.
The two-year rule applies to related-party exchanges, stipulating that both properties involved must be held for at least two years after the exchange. This rule prevents investors from swapping properties with family members solely for tax benefits.
If a taxpayer exchanges property with a close relative and sells it within two years, the transaction may be deemed a taxable event, nullifying the 1031 deferral.
Exceptions to the two-year holding period are allowed only if the subsequent disposition of the property is due to the death of the Exchanger or related person, the compulsory or involuntary conversion of one of the properties under IRC §1033, or the Exchanger can establish that neither the exchange nor the disposition of the property was designed to avoid the payment of Federal income tax as one of its principal purposes.
Intriguing read: 1031 Exchange Property
The IRS will generally view a transaction as yielding the same result as if the Exchanger swapped properties with a related party, and then the related party immediately sold the property acquired, violating the two-year holding requirement.
In a series of exchanges involving related partnerships, the IRS ruled that Section 1031(f) would not trigger gain recognition if neither related party was cashing out of their investment in real estate and each related party represented that they would hold their Replacement Property for the required two years following their exchange.
Intriguing read: What Are the Irs Rules for a 1031 Exchange
Exchange Request
If you're considering a 1031 exchange with a family member, you'll need to follow strict conditions to qualify. Both parties must hold the exchanged properties for two years post-transaction.
A 1031 exchange with a family member can be completed, but it's essential to understand the related-party rules. The IRS has guidelines in place to prevent tax abuse.
You'll need to ensure the exchange serves investment rather than tax-avoidance purposes. This means the property must be held for investment, not personal use.
Engaging in a 1031 exchange with a family member can be advantageous, but it's crucial to follow IRS guidelines.
Broaden your view: Can You Do a 1031 Exchange on a Rental Property
Frequently Asked Questions
Who is considered a related party to a trust?
Related parties to a trust include spouses, ancestors, and lineal descendants, as well as entities owned more than 50% by individuals, corporations, trusts, or partnerships
Do both parties have to agree to 1031 exchange?
For a 1031 exchange in an LLC with two 50-50 owners, both parties must mutually agree to relinquish the property and complete the exchange. This joint agreement is a critical requirement for a successful 1031 exchange in this scenario.
Sources
- https://www.accruit.com/blog/1031-exchange-related-party-rules-and-constructive-ownership
- https://www.rangerminerals.com/1031-exchange-rules-and-requirements/
- https://atlas1031.com/exchange-types/reverse-1031-exchange/
- https://www.ipx1031.com/related-party-exchanges/
- https://avidianwealth.com/financial-insights/articles/1031-exchanges/
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