The IRS “Related Party” Rules: The Hidden Danger Behind Many Failed 1031 Exchanges

When most investors think about 1031 exchanges, they focus on deadlines, property types, and reinvesting their proceeds correctly. But one IRS rule quietly invalidates more exchanges than people realize: the Related Party Rule.If a 1031 exchange involves certain relatives, business entities, or partnerships — and the transaction isn’t structured properly — the IRS can retroactively disqualify the entire exchange. This can trigger tens or hundreds of thousands of dollars in unexpected taxes.Here’s what investors need to know.

 What Does the IRS Consider a “Related Party”?

For tax purposes, the IRS has a very specific definition of who counts as related. It includes:

Individuals

ParentsChildrenSiblingsGrandparentsGrandchildrenSpouses(Cousins are NOT considered related parties under IRS rules.)

Entities

A corporation where you own more than 50%A partnership where you own more than 50%Any entity you controlTrusts and estates in which you have significant ownershipThis means you can’t simply sell to your child or buy from your parents and expect full tax deferral — even though the properties may be perfectly like-kind.

 Why Related-Party Exchanges Are Risky

The IRS is concerned that related parties may use an exchange to manipulate tax outcomes — such as shifting basis, avoiding recognition of gain, or cashing out tax-deferred proceeds.Because of this, the IRS imposes a strict rule:

Both parties must hold their new properties for at least TWO YEARS.

If either side sells or disposes of their property within 2 years, the IRS can collapse the exchange and retroactively tax the first transaction.This is known as the Two-Year Holding Rule.

Situations That Commonly Cause Exchanges to Fail

1. You sell a property to your brother and buy a replacement from an unrelated seller.

This fails because the IRS assumes the brother could sell soon after — breaking the two-year rule.

2. You buy a replacement property from your parents.

The transaction is automatically scrutinized, and the exchange may be denied altogether.

3. You sell to a related party who wants to cash out.

If they sell within two years, your entire exchange becomes taxable.

4. Indirect related-party sales through entities you control.

Forming an LLC doesn’t hide ownership from the IRS.

When Related-Party Exchanges Are Allowed

There are a few narrow situations where related-party exchanges can succeed:

 Both parties want long-term ownership

If neither party sells their property for at least two years, the IRS generally accepts the exchange.

 You exchange properties with a related party with no tax advantage gained

Example: two siblings swap properties of similar value and similar basis.

 The related party is also doing a 1031 exchange

If both sides exchange into like-kind property, the intent is clearly tax-deferral, not cash-out.

 Exceptions to the Two-Year Rule

The IRS allows exceptions only when:One party diesThere is involuntary conversion (e.g., eminent domain)Circumstances change for reasons not motivated by tax avoidanceThese exceptions are rare and heavily scrutinized.

Related-party 1031 exchanges are not impossible, but they are high risk and one of the most common ways an exchange gets denied by the IRS.If you’re considering a transaction involving family members, business partners, or an entity you control, it is crucial to:Work with a Qualified IntermediaryConsult a CPA or tax attorneyEnsure both parties intend to hold their new properties for at least two years

 Thinking about a 1031 exchange involving a family member or related entity?

Let us help you structure it properly — and avoid costly IRS pitfalls.