Understanding Related Party Rules in 1031 Exchanges
When it comes to 1031 Exchanges, one of the trickiest areas investors run into involves related party transactions. The IRS has long been concerned that taxpayers might use family members, partnerships, or entities they control to sidestep taxes through basis shifting or other abusive strategies. To prevent this, the IRS relies on specific definitions of what counts as a related party, outlined in Internal Revenue Code Sections 267(b) and 707(b)(1).
Here’s what you need to know.
Who Qualifies as a Related Party?
The IRS casts a wide net when defining related parties. These aren’t limited to family ties—business relationships and ownership stakes can create related party status as well. Some of the key categories include:
Family members: siblings, spouses, parents, children, grandchildren, and other direct ancestors or descendants.
Corporations: if more than 50% of the value of the stock is owned—directly or indirectly—by one person, trust, or related entity.
Controlled corporations: two corporations that are part of the same controlled group.
Trust relationships: grantors, fiduciaries, and beneficiaries may be related depending on the structure.
Charitable organizations: a nonprofit under Section 501 can be related if it’s controlled by a person or that person’s family.
Corporation and partnership overlap: if the same person owns more than 50% of both.
S corporations and C corporations: when majority ownership overlaps.
Partnerships: a partnership and anyone who owns more than 50% of its capital or profits interest, as well as two partnerships with the same majority owners.
Estates: executors and beneficiaries are considered related.
Notably, some relationships do not qualify as related. For example, two separate trusts created by a husband and wife are not related because they have different grantors.
Constructive Ownership Rules
When determining ownership percentages, the IRS applies constructive ownership rules under Section 267(c). This means that stock or partnership interests may be considered owned by an individual if held by certain related persons or entities, even if not held directly.
Why These Definitions Matter for 1031 Exchanges
You might be wondering: Why does all this matter?
The IRS wants to ensure 1031 Exchanges are used for legitimate investment purposes, not just to shuffle properties among family members or business entities to avoid taxes. If your transaction involves a related party, stricter rules apply—such as the two-year holding requirement—and in some cases, exchanges may be outright disallowed.
Understanding the definition of a related party is the first step in avoiding a disqualified exchange. For example:
Selling to your sibling’s LLC could trigger related party rules if ownership crosses the 50% threshold.
Structuring a deal with a trust you control may not qualify.
On the other hand, restructuring ownership so a party holds less than 50% may remove the related party concern.
The Bottom Line
The IRS rules around related parties are complex, but they serve an important purpose: preventing tax abuse in 1031 Exchanges. For investors, knowing who qualifies as a related party—and how ownership attribution works—can mean the difference between a valid exchange and a rejected one.
Because mistakes in this area can be costly, investors should always consult with qualified tax advisors before structuring a 1031 Exchange that may involve family members, partnerships, or commonly owned entities.
