Related Party Rules for 1031 Like-Kind Exchanges

The related party rules for 1031 exchanges require you and anyone you’re closely connected to — by family, ownership, or trust relationship — to hold the properties you swap for at least two years, and they let the IRS unwind the whole deferral if the exchange looks designed to shift tax basis inside the group. The rules live in Section 1031(f), and they draw their definition of “related” from Sections 267(b) and 707(b)(1) of the tax code.¹ Miss them and you owe the capital gains tax you tried to defer, often with a 20% accuracy-related penalty on top.

One threshold point before the rules themselves: since 2018, only real property qualifies for 1031 treatment at all. Equipment, vehicles, artwork, patents, and other personal or intangible property are out, related party or not.²

Who Counts as a Related Party

Three categories of relationship trigger the rules: family, controlled entities, and trusts.

Family

Related family includes your spouse, siblings (including half-siblings), parents, grandparents, children, and grandchildren.³ Aunts, uncles, cousins, in-laws, and stepchildren who haven’t been legally adopted are not on the list. An exchange with a cousin isn’t a related party exchange by relationship alone, though a shared business interest could still create one through the entity rules below.

Business Entities

A corporation is related to you if you own more than 50% of its stock by value. A partnership is related if you hold more than 50% of its capital or profits interest.³ Two corporations, or two partnerships, controlled by the same people are related to each other. The threshold is sharp: exactly 50% is not related; 50.1% is.

Trusts

Related trust relationships include grantor to fiduciary, fiduciary to beneficiary of the same trust, and fiduciaries of two trusts created by the same grantor. A trust is also related to a corporation when the trust or its grantor owns more than 50% of the corporation’s stock.³ Estate plans that use multiple family trusts often trip these rules without the family realizing it.

Constructive Ownership Can Pull You In

You can be treated as owning stock or partnership interests you don’t actually hold. Under the constructive ownership rules in Section 267(c), interests held by your spouse, siblings, parents, and lineal descendants are attributed to you.⁴ If your spouse owns 30% of a corporation and you own 25%, you’re treated as owning 55% for related party purposes, and the corporation is related to you.

Ownership held by a partnership, corporation, or trust flows through to the owners in proportion to their interests. One important limit: interests attributed to you through family or partnership rules can’t then be re-attributed from you to someone else. Interests attributed to you from an entity, though, are treated as if you owned them directly, and those can be re-attributed.⁴ This is where the analysis gets complicated, and most taxpayers with layered holdings need a tax advisor to map the chain before signing anything.

The Two-Year Holding Rule

The central restriction is simple to state: both you and the related party must hold the properties received in the exchange for at least two years. The clock starts on the date of the last transfer that completes the exchange. If either side disposes of its property before that two-year mark passes, the deferral is retroactively lost.¹

“Disposes” is read broadly. A sale to a third party is the obvious case, but another exchange, a gift, or any transfer that moves ownership away from the original recipient counts as well. When a premature disposition happens, the deferred gain is recognized in the year of the disposition, not the year of the original exchange. That timing affects your estimated tax payments.

The rule exists because without it, related parties could swap properties so the one planning to sell ends up holding the property with the higher tax basis, shrinking the taxable gain on the eventual sale. Forcing both sides to keep the property for two years takes the quick basis rotation off the table.

The Three Exceptions

An early disposition doesn’t kill the deferral in three situations:

Death of either party after the exchange. A transfer that follows doesn’t trigger recognition.¹
Involuntary conversion, such as destruction by disaster or a government taking, but only if the threat arose after the exchange was completed.¹
No tax avoidance purpose. If you can establish to the satisfaction of the Secretary that neither the exchange nor the early disposition was principally motivated by tax avoidance, the disposition doesn’t trigger gain.

The third exception is the one most taxpayers try to use and the hardest to win. There are no published regulations defining what satisfies the standard. The strongest evidence is showing that no basis shifting occurred, because both properties carried comparable adjusted bases at the time of the swap. Corporate restructurings and court-ordered transfers also fit the pattern. If you’re planning to rely on this exception, a private letter ruling before the transaction is the safest route.

The Anti-Abuse Catch-All

Holding for two years isn’t always enough. Section 1031(f)(4) lets the IRS disqualify an exchange that is “part of a transaction (or series of transactions) structured to avoid the purposes” of the related party rules.¹ Congress added this so taxpayers couldn’t run out the clock and then complete a pre-planned sale.

The archetypal case: you and a sibling swap, both hold for two years and a day, and then the sibling sells. The holding period is technically satisfied. But if the IRS can show the sale was pre-arranged and the swap had no purpose other than moving basis into the seller’s hands, it can treat the original exchange as a taxable sale. Contemporaneous documentation of an independent business reason for the exchange is the practical defense.

Why Basis Shifting Is the Target

The point of these rules becomes clearer with a concrete pattern. Say you own Property A with a $100,000 basis and a $500,000 value — $400,000 of built-in gain. Your sibling owns Property B, also worth $500,000, with a $450,000 basis and only $50,000 of built-in gain. You swap. Your sibling now holds Property A but carries their old $450,000 basis into it. If they sell to an outsider, they recognize $50,000 of gain instead of $400,000. The family’s total gain hasn’t vanished, but it has moved to the person who isn’t selling.

This is what the IRS looks for. When the group’s combined tax bill drops because basis was shuffled before a sale, the transaction fails the economic substance test. The two-year holding rule is the front-line guardrail, Section 1031(f)(4) sweeps in the rest, and the penalty for a recharacterized transaction can be 20% of the underpayment, rising to 40% if the IRS concludes the arrangement lacked economic substance.⁵

Using a Qualified Intermediary Doesn’t Help

Some taxpayers have tried to route a related party purchase through a Qualified Intermediary, hoping the intermediary’s involvement would break the related party chain. Revenue Ruling 2002-83 closed that door.⁶

If you use an intermediary to acquire replacement property that a related party is selling, and the related party walks away with cash, the IRS treats the transaction as if you bought directly from the related party and they cashed out. The intermediary’s presence doesn’t change the outcome. And this applies even if you plan to hold the replacement property for more than two years, because the problem is the cash going to the related seller, not the holding period. Before an intermediary acquires any replacement property, confirming that none of the sellers are related to you — including through constructive ownership — is essential.

What It Costs If the Exchange Fails

When the deferral collapses, you owe capital gains tax on the gain you originally deferred. Long-term capital gains rates run from 0% to 20% depending on income.⁷

Real estate typically brings a second layer. Gain attributable to depreciation you previously claimed is taxed at a maximum rate of 25% regardless of income.⁷ And taxpayers with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly) owe an additional 3.8% Net Investment Income Tax on the recognized gain. Those thresholds are not indexed for inflation.⁸

Layer the 20% accuracy-related penalty on top when the IRS concludes the exchange lacked economic substance, and a failed related party exchange often costs more than if you had simply paid the capital gains tax on the original sale.⁵

Reporting on Form 8824

Every 1031 exchange with a related party is reported on IRS Form 8824. In the exchange year, you complete Parts I and II, disclosing the related party’s name, taxpayer identification number, and relationship to you.⁹ Part II asks whether either party disposed of the property during the tax year, which is how the IRS tracks the holding period.

Form 8824 has to be filed again for each of the next two tax years — three returns in total.¹⁰ If neither party has disposed of the property in a follow-up year, Part III can be skipped. If either has, you report the deferred gain unless one of the three exceptions applies. Claiming the tax avoidance exception on line 11 requires a written explanation attached to the return; the checkbox alone is not sufficient.⁹

Skipping the form doesn’t automatically void the exchange, but it invites scrutiny and can extend the statute of limitations on examining the transaction. Given how closely the IRS already watches related party exchanges, the form is not the place to cut corners.

1
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
2
Internal Revenue Service. Like-Kind Exchanges – Real Estate Tax Tips
3
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
4
eCFR. 26 CFR 1.267(c)-1 – Constructive Ownership of Stock
5
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
6
Internal Revenue Service. Revenue Ruling 2002-83
7
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
8
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
9
Internal Revenue Service. Like-Kind Exchanges – Form 8824
10
Internal Revenue Service. Instructions for Form 8824 – Like-Kind Exchanges