Related Party 1031 Exchange: The 2-Year Rule and Its Exceptions
You can do a 1031 exchange with a related person, but §1031(f) takes the deferral away if either of you disposes of the exchanged property within 2 years of the last transfer in the exchange. The gain isn’t reached back to the exchange year; it’s recognized in the year of the disposition. There are three exceptions (death, involuntary conversion, and no tax-avoidance purpose), and a qualified intermediary doesn’t get you around any of it.
Why the rule exists
Related parties can swap a low-basis property for a high-basis one and then sell the high-basis property with little tax. The IRS quotes the legislative history in Rev. Rul. 2002-83: when an exchange between related parties is followed shortly by a disposition, the parties have “cashed out” of the investment. Section 1031(f) is aimed at that basis shift.
Who counts as related
Section 1031(f)(3) borrows the relationships in §267(b) and §707(b)(1).
| Relationship | Source |
|---|---|
| Family: brothers and sisters (whole or half blood), spouse, ancestors, lineal descendants | §267(b)(1), (c)(4) |
| You and a corporation you own more than 50% of by value, directly or indirectly | §267(b)(2) |
| Two corporations in the same controlled group | §267(b)(3) |
| Grantor and fiduciary of a trust; fiduciary and beneficiary; fiduciaries of two trusts with the same grantor | §267(b)(4)-(7) |
| A trust fiduciary and a corporation more than 50% owned by the trust or its grantor | §267(b)(8) |
| A corporation and a partnership with the same persons owning more than 50% of each | §267(b)(10) |
| Two S corporations, or an S and a C corporation, with more than 50% common ownership | §267(b)(11), (12) |
| An executor and a beneficiary of the estate (except for a pecuniary bequest) | §267(b)(13) |
| A partnership and a partner owning more than 50% of capital or profits | §707(b)(1)(A) |
| Two partnerships with more than 50% common ownership | §707(b)(1)(B) |
Ownership is counted with the attribution rules of §267(c). Stock owned by an entity is treated as owned proportionately by its owners, and you’re treated as owning what your family owns. So a corporation owned 30% by you and 30% by your daughter is related to you. For partnerships, §707(b)(3) applies the same attribution rules except the partner rule in §267(c)(3).
Notice what isn’t on the family list: in-laws, aunts and uncles, nieces and nephews, cousins. The Form 8824 instructions put it this way: spouse, child, grandchild, parent, grandparent, brother, sister, or a related corporation, S corporation, partnership, trust, estate or tax-exempt organization.
The 2-year rule
Under §1031(f)(1), the exchange loses nonrecognition if, before 2 years after the last transfer that was part of the exchange, either the related person disposes of the property you gave them or you dispose of the like-kind property you got from them.
Three dispositions don’t count (§1031(f)(2)):
| Exception | Form 8824 line |
|---|---|
| Disposition after the death of either party | 11a |
| Involuntary conversion, if the exchange happened before the threat or imminence of the conversion | 11b |
| You establish to the IRS’s satisfaction that neither the exchange nor the disposition had tax avoidance as one of its principal purposes | 11c |
For line 11c, the Form 8824 instructions say tax avoidance generally won’t be seen as a principal purpose for a disposition in a nonrecognition transaction, an exchange where the related parties get no tax advantage from shifting basis, or an exchange of undivided interests that leaves each party holding a whole property or a larger undivided interest.
The 2 years can stretch. Under §1031(g), the clock is suspended while a holder’s risk of loss is substantially diminished by a put, someone else’s right to acquire the property, a short sale, or any other transaction. And §1031(f)(4) denies nonrecognition to any exchange that’s part of a transaction structured to avoid the related party rules.
Buying replacement property from a related party
Rev. Rul. 2002-83 covers this setup: you sell to an outsider through a QI, and the QI buys your replacement from a relative or a related entity.
The facts, scaled to dollars for illustration (the ruling uses $150x and $50x): A owns Property 1, worth $1,500,000 with a $500,000 basis. A’s related party B owns Property 2, worth $1,500,000 with a $1,500,000 basis. A sells Property 1 through a QI to an unrelated buyer for cash. The QI uses the cash to buy Property 2 from B and deeds it to A.
On paper A exchanged with an unrelated QI. In substance, B ended up with the cash and A ended up holding the property while deferring the low-basis gain. The IRS treated it as structured to avoid §1031(f) and applied §1031(f)(4). A’s exchange is fully taxable: $1,500,000 amount realized less $500,000 basis is a $1,000,000 gain.
The holding is tied to one fact: the related party “receives cash or other non-like-kind property for the replacement property.” The Form 8824 instructions (line 7) say the same, and tell you not to file Form 8824 in that situation unless a line 11 exception applies. Report the disposition as a sale instead.
When the related seller is also exchanging
If the related party sells you the replacement and does its own 1031 exchange with the proceeds, instead of keeping cash, the fact the ruling turns on is missing. Rev. Rul. 2002-83 doesn’t address that case and gives no safe harbor for it. What the primary sources do say is the line 11c guidance above, that a disposition in a nonrecognition transaction generally isn’t treated as tax-motivated. Structuring this kind of deal is a job for a tax attorney before the contracts are signed, and the 2-year rule and Form 8824 Part II still apply.
Reporting: Form 8824 for three years
Form 8824 line 7 asks whether the exchange of the property given up or received was made with a related party, directly or indirectly (such as through an intermediary). A “yes” sends you to Part II.
| Line | What it asks |
|---|---|
| 8 | Related party’s name, relationship, identifying number and address |
| 9 | Did the related party sell or dispose of any of the property it received from you during this tax year (and within 2 years of the last transfer)? |
| 10 | Did you sell or dispose of any of the like-kind property you received during this tax year (and within 2 years)? |
| 11a-c | Which exception applies, if any |
You file Form 8824 for the year of the exchange and for each of the 2 following years. If lines 9 and 10 are both “No” in a later year, you stop after Part II. If either is “Yes” and no exception applies, you complete Part III and report the deferred gain from line 24 on that year’s return as if the exchange had been a sale.
To see what a taxable outcome would cost, use the capital gains calculator.
Sources
Questions people ask
Can I do a 1031 exchange with a family member?
Yes, but under §1031(f) the deferral is lost if either of you disposes of the exchanged property within 2 years of the last transfer, unless an exception applies. The gain is taxed in the year of that disposition.
Can I buy my replacement property from a relative through a qualified intermediary?
Not if the relative ends up with cash. Rev. Rul. 2002-83 holds that the exchange fails when the related party receives cash or other non-like-kind property for the replacement property.
Who counts as family for the related party rules?
Brothers and sisters (including half blood), spouse, ancestors and lineal descendants, under §267(c)(4). In-laws, aunts, uncles and cousins aren't on that list, though entity ownership rules can still make them related through a corporation, partnership or trust.