Buying Your Replacement Property From a Relative: When the IRS Allows It

Family members often own property the investor already knows well: a parent's rental, a sibling's commercial building, a parcel next to the family farm. When a 1031 exchange needs a replacement quickly, buying from a relative can look like the easiest path.

It is also one of the easiest ways to lose the deferral. The tax code treats transactions between related parties with suspicion, and acquiring replacement property from a related person is treated more strictly than many investors expect.

Who counts as a related party?

For these purposes, related parties generally include:

• ›Your spouse, children, grandchildren, parents, grandparents and siblings
• ›Entities you control, such as corporations or partnerships in which you hold more than 50 percent
• ›Certain trusts and fiduciary relationships

Aunts, uncles, cousins and in laws are generally not related parties under this definition, although arrangements designed to route transactions through them can still attract scrutiny.

Why does the IRS care about related party transactions?

Because related parties can shift basis and gain between themselves.

Imagine an investor with a low basis property and a relative with a high basis property. If the investor exchanges into the relative's property and the relative then sells the investor's old property, the family may effectively cash out while paying little tax, because the relative's high basis absorbs the gain. That is basis shifting, and the related party rules exist to prevent it.

What happens when you buy replacement property from a relative?

The IRS has taken the position, set out in Revenue Ruling 2002-83, that acquiring replacement property from a related party generally does not qualify when the related party receives cash from the transaction.

The logic is that the related party has effectively cashed out of an investment in real estate through a transaction structured as your exchange. In that situation, the exchange can fail even if you hold the replacement property for years.

This is stricter than the rule for exchanging directly with a relative, where both parties exchange properties and each must hold for two years.

Are there any situations where it can work?

Yes, but they are narrow and fact specific.

When the relative is also doing a 1031 exchange. If the relative selling to you reinvests their proceeds into their own replacement property through a qualified exchange, there is no cash out. Private letter rulings have allowed arrangements along these lines, although private rulings apply only to the taxpayers who requested them.

When there is no tax advantage from the arrangement. If the relative's gain or tax position means no basis shifting occurs, some practitioners consider the risk lower. Proving that requires careful analysis.

When there are non tax reasons and full documentation. A genuine business purpose does not by itself cure a basis shift, but it matters to the overall facts.

In practice, many advisers recommend avoiding related party replacement property entirely unless the relative is also completing an exchange and the structure has been reviewed in detail.

What about selling your relinquished property to a relative?

That is generally more workable. Selling to a related party, and buying replacement property from an unrelated seller, is usually permitted, because you are not cashing out the related party. Related party exchange rules may still apply in some cases, including a two year holding requirement where properties are exchanged directly between related persons.

The distinction is important. Selling to family is often fine. Buying from family is where the strict rule bites.

What if the relationship is through an entity?

The same principles apply when the seller is an entity you control, such as a partnership or LLC in which you own more than half. Buying replacement property from your own family partnership can be treated the same way as buying from a relative directly.

Families who own several properties across different entities should map the ownership before planning an exchange, because a transaction that looks arm's length can be related party once the entities are traced through.

What should you do instead?

If the family property is genuinely the right investment, consider other structures:

• ›Buy it outside the exchange with other funds, and use exchange proceeds for unrelated replacement property.
• ›Have the relative complete their own exchange, with full advice on both sides.
• ›Delay the purchase until after your exchange, if timing allows.

If speed is the reason for considering a relative's property, remember that passive replacement options such as Delaware Statutory Trust interests from unrelated sponsors can often close within the exchange period without related party issues.

What does a failed related party purchase cost?

If the exchange fails because the replacement came from a related party who cashed out, the sale of your relinquished property is treated as fully taxable in the year it occurred. That brings back the entire deferred gain, including depreciation recapture at up to 25 percent, the net investment income tax where it applies, and state tax.

On a long held property, that can be hundreds of thousands of dollars, due for a year you thought was tax free, often discovered on examination years later with interest added. Compared with that risk, the inconvenience of finding an unrelated replacement is small.

What to do first

Before identifying any property owned by a family member or a family entity, tell your Qualified Intermediary and CPA who the seller is and how they are related to you. Ask specifically whether the seller will receive cash, and whether they plan to exchange. Get the answer before day 45, because once a related party property is identified and acquired, unwinding the problem is far harder.

Nothing here is tax, legal or investment advice. Related party rules are technical and depend on your facts. Confirm your position with your CPA and attorney before acting.