1031 Exchange Related Party Rules: What Investors Need to Know
The 1031 Exchange is one of the most powerful tools real estate investors have to defer capital gains taxes, but not every transaction is straightforward. One of the more complicated areas involves related party exchanges. Because of past abuse, the IRS keeps a close watch on these transactions, and there are special rules every investor should understand before moving forward.
Why the IRS Watches Related Party Exchanges Closely
In the past, some taxpayers tried to use 1031 Exchanges between family members or closely held entities to game the system. The most common strategy was basis shifting — swapping a low-basis property (big tax bill if sold) for a high-basis property (little or no gain), allowing one party to defer taxes while the other cashed out with little consequence.
To curb this, the IRS issued rules that don’t outright ban related party exchanges but place strict conditions on them.
Who Counts as a Related Party?
The IRS definition of a “related party” comes from Sections 267(b) and 707(b) of the Internal Revenue Code. It includes:
Immediate family (siblings, parents, children, grandchildren, and spouses)
Entities where you own more than 50% (corporations, partnerships, or LLCs)
Interestingly, not all relatives are included. Stepparents, cousins, aunts, uncles, and in-laws are not considered related parties under these rules.
The Two-Year Holding Rule
If you exchange property with a related party, both sides must generally hold the property for at least two years after the transaction.
Sell too soon, and the IRS will undo the exchange — meaning capital gains and depreciation recapture taxes become due.
The two years begin on the date of the last property transfer in the exchange.
This rule exists to prevent quick “flip” strategies between related parties.
Exceptions to the Rule
There are a few situations where disposing of a property before the two-year mark won’t disqualify the exchange:
The related party also conducts a 1031 Exchange with their sale proceeds
Either party passes away
Multiple co-owned properties are consolidated into full ownership
A forced sale occurs (such as an involuntary conversion under Section 1033)
The taxpayer can prove the exchange had a legitimate business purpose other than avoiding taxes
Buying vs. Selling with a Related Party
The rules differ depending on whether you’re selling to or buying from a related party:
Selling to a related party is generally allowed, as long as both parties meet the two-year holding requirement.
Buying from a related party is usually problematic. In most cases, this creates a basis-shifting situation, which the IRS directly prohibited in Revenue Ruling 2002-83.
The main exception: if the related party is also completing their own 1031 Exchange, the transaction may still qualify.
Additional Consideration: IRS Scrutiny and Audit Risks
One point often overlooked is that related party exchanges are red flags for IRS auditors. Even if your transaction fits within the rules, it may attract closer examination. Investors should:
Keep thorough documentation of the business purpose behind the exchange
Maintain records proving compliance with the two-year holding requirement
Be prepared to show that tax avoidance was not the primary motive
Failing to document intent and compliance is one of the fastest ways to lose the tax deferral.
