IRC §1031(f) provides that a tax-deferred exchange will be disallowed if the exchanger trades property with a “related property”, and either party sells one of the exchange properties within two years. The purpose behind the rule is to prevent people from engaging in sham property swaps to shift their cost basis and then cashing out of properties with much lower tax consequences.
Under Revenue Ruling 2002-83, you generally cannot purchase your replacement property from a related party, regardless of the two-year holding period, unless the related party also conducts a §1031 exchange involving the same property. However, you likely can sell your relinquished property to a related party, provided you purchase your replacement property from a legitimate third party. This is admittedly an over-simplification of numerous codes, regulations and court cases. Application of the law may depend on which Circuit Court of Appeals has jurisdiction over your state.
Be careful about being too clever in these situations. Even if you involve additional entities or extra steps in a series of transactions that achieve the same result as a direct related-party exchange, the IRS will apply an “economic substance” test and likely disallow the non-recognition of gain.
For a §1031 exchange, the term “related party” includes your:
- Full or half-siblings
- Business entity of which you own, directly or indirectly, at least 50%
It is possible to have no ulterior motive in transacting with a related party, and still end up having your exchange disallowed. If you are considering buying or selling an exchange property with a relative or business entity of which you own an interest, immediately consult with an experienced tax professional.
This information is for educational purposes only and does not constitute direct investment advice or a direct offer to buy or sell an investment, and is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor. The views of this material are those solely of the author and do not necessarily represent the views of their affiliates.
Investing in real estate and 1031 exchange replacement properties may involve significant risks. These risks include, but are not limited to, lack of liquidity, limited transferability, conflicts of interest, loss of entire investment principal, declining market values, tenant vacancies, and real estate fluctuations based upon a number of factors, which may include changes in interest rates, laws, operating expenses, insurance costs and tenant turnover. Investors should also understand all fees associated with a particular investment and how those fees could affect the overall performance of the investment.
Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Insurance products offered through Concorde Insurance Agency, Inc. (CIA). 1031 Capital Solutions is independent of CIS, CAM and CIA.