The rules surrounding related parties in §1031 exchanges often lead to confusion and misconceptions. While many believe that transactions involving related parties are prohibited under the Internal Revenue Code (IRC) Section 1031, exceptions exist that allow such exchanges under specific conditions.
March 9, 2025
By Al DiNicola, AIF®
DST §1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC, Member of FINRA/SIPC
We receive calls from investors selling their business and the associated real estate to a family member. The investor may be seeking to do a §1031 exchange into a Delaware Statutory Trust (DST) by selling the real estate property to a related party taking over their business. The seller wants to move on to a more passive investment for the real estate and potentially utilize a gain on the business sale via an Opportunity Zone investment. This article explores the related party rules, clarifies who qualifies as a related party, and outlines the exceptions and considerations investors need to know to navigate these transactions successfully.
What Is a Related Party in a §1031 Exchange?
Under Sections 267(b) and 707(b)(1) of the IRC, a related party in a §1031 exchange includes:
- Immediate Family Members: Siblings, spouses, ancestors (parents, grandparents), and descendants (children, grandchildren).
- Business Entities with Significant Ownership or Control: Entities where the exchanger holds more than 50% ownership, such as corporations, partnerships, or trusts; two corporations that are members of the same controlled group; and corporations and partnerships with more than 50% direct or indirect common ownership.
- Certain Fiduciary Relationships: For example, an exchanger and the fiduciary of a trust.
- Affiliated Businesses: Entities directly or indirectly controlled by the exchanger or their immediate family.
This broad definition ensures that any transaction involving individuals or entities with close personal or financial ties is subject to heightened IRS scrutiny to prevent abuse.
Why Related Party Rules Exist
Before 1984, related party transactions in §1031 exchanges were prone to manipulation. For example, related parties could shift tax liabilities or inflate property values, undermining the integrity of the tax system. To address this, the Tax Reform Act of 1984 introduced safeguards, including the two-year holding period, to ensure that these transactions are legitimate and not structured to avoid taxes.
Key Rules and Exceptions for Related Party Exchanges
Direct Exchanges Between Related Parties
When two related parties directly exchange properties, both parties must hold the exchanged properties for at least two years following the transaction. If either party disposes of their property within this period, the IRS retroactively revokes the tax deferral, and the original capital gain becomes taxable in the year of disposal.
However, exceptions to the two-year holding rule exist, including:
- Death of a Party: If one party dies within the two-year period, the rule is waived.
- Involuntary Dispositions: Events like eminent domain or natural disasters that force the sale of a property.
- IRS Approval: If the IRS determines the transaction was not structured to avoid taxes.
Selling to a Related Party
Selling relinquished property to a related party in a §1031 exchange is generally straightforward, as long as the transaction complies with IRC Section §1031 guidelines, including the requirement that the property is held for investment or business purposes. No specific holding period applies to the related party acquiring the relinquished property.
Buying from a Related Party
Purchasing replacement property from a related party comes with stricter requirements. The related party selling the property must also be conducting a §§1031 exchange for the transaction to qualify. If the related party is not engaging in their own exchange, the transaction will likely be disqualified.
Documentation and IRS Compliance
Related party exchanges are subject to heightened scrutiny, making thorough documentation critical. Investors should maintain detailed records, including:
- Property appraisals
- Contracts and exchange agreements
- Correspondence with the related party
- IRS Form 8824, which discloses the nature of the relationship and the transaction details
Planning for Success in Related Party Exchanges
To navigate the complexities of related party rules in §1031 exchanges, consider the following:
- Understand the Two-Year Holding Requirement: Ensure compliance with the holding period for direct exchanges to avoid retroactive tax consequences.
- Consult Professionals: Work with tax advisors, legal professionals, and a qualified intermediary to ensure the exchange complies with all regulations.
- Maintain Transparency: Keep detailed records and file all required forms to demonstrate the legitimacy of the transaction.
Related party rules in §1031 exchanges are designed to protect the integrity of the tax system while still allowing legitimate transactions to occur. By understanding these rules, planning carefully, and seeking professional guidance, investors can leverage §1031 exchanges involving related parties to achieve their investment goals while staying compliant with IRS regulations.
NAMCOA® is a SEC registered investment advisory firm that provides comprehensive portfolio management, financial planning, and fiduciary decision-making services on behalf of retirement plan sponsors. Our Difference is summarized by our fiduciary approach which enables us to better meet portfolio and retirement plan objectives, resulting in stronger risk adjusted returns for investors and peace of mind for Clients. We also focus on alternative real estate investment. Many real estate investors are seeking tax deferred solutions utilizing §1031 exchanges or Opportunity Zones.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your §1031 exchange and suited for your investment future. For more information on how to properly set up an IRC §1031 Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 5 Centerpointe Drive, Ste. 400 Lake Oswego, OR, 97035. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
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