Related parties under IRC 267(b) can exchange with each other, but both sides have to hold their properties for two years or the exchange is disqualified and the deferred gain comes due. If either party sells inside that window, the deferral is lost. Arm's-length pricing and clean documentation are what keep the deal defensible.
You can follow every rule of a 1031 exchange - hold your new property for years, price the deal at fair value, file every form on time - and still owe the tax you thought you had deferred, because of something the person on the other side did. That is the quiet risk in a related-party exchange.
A 1031 exchange lets you defer the tax on a gain by exchanging one investment property for another. It becomes a related-party exchange when the person you buy from, sell to, or swap with is someone the IRS treats as connected to you. These deals are legal. But they carry a two-year holding requirement that binds both sides, and breaking it disqualifies the exchange and makes the deferred tax due right away.
Who the IRS counts as a related party
Under IRC Section 267(b), related parties include:
- Your spouse
- Siblings, including half-siblings
- Parents, grandparents, and other ancestors
- Children, grandchildren, and other lineal descendants
- Any entity in which you own more than 50% of the capital or profits interest
- Any corporation in which you own more than 50% of the stock
The traps tend to hide in the entities. Your single-member LLC counts, because the IRS looks straight through it to you. So does a partnership where you are the controlling member, and your child's LLC if you hold more than half of it. Two LLCs you both control are related to each other, even when they look completely separate on paper.
The two-year rule, and how it breaks
Both parties have to hold their properties for at least two full years from the closing date. If either one sells inside that window, the other's deferred gain becomes taxable - in the year of the sale, and no matter how good the reason. A medical emergency, a job loss, financial hardship: the rule does not care. Two exceptions exist - a disposition caused by death, or an involuntary conversion such as condemnation or a casualty - but both are narrow.
Three versions of the same deal show how much rides on the hold.
The clean one: you and your brother each own a rental property and exchange them. You both hold for at least two years. The exchange stands, and you both defer your gains.
The one that bites: the same swap, but 14 months later your brother hits financial trouble and sells the property he received from you. Your deferred gain is now taxable. You did nothing wrong; the exchange is disqualified simply because your related party sold within two years.
The one that usually fails: trying to engineer around related-party status with intermediary entities or a chain of steps. The IRS reads substance over form. If the real parties are related, the two-year rule applies no matter how many entities sit in between.
Buying works the same as selling
The rule is symmetric. If you acquire your replacement property from your father, both of you are bound by the two-year hold, and either of you selling inside it disqualifies the exchange.
Say your father sells you his commercial building as your replacement property, and you hold it for three years. If he meanwhile sells a property he received from a separate transaction within 18 months, and that transaction is connected to your exchange, your deferral could be at risk. The obligation runs to both sides, not just the one doing the exchange on paper.
What a clean deal looks like
A related-party exchange that holds up tends to share four features.
- Arm's-length pricing. An independent appraisal of both properties documents that the terms reflect fair market value. Below-market pricing between family members invites scrutiny.
- A qualified intermediary. Even between relatives, a qualified intermediary - the neutral party that holds the funds and facilitates the exchange - keeps the money and paperwork separate from both sides, which demonstrates proper procedure.
- A written acknowledgment of the two-year commitment. Both parties putting the obligation in writing, along with what happens if someone faces unexpected circumstances, heads off family conflict and shows good intent.
- Disclosure of the relationship. Form 8824 Part II requires related-party exchanges to be reported. Leaving it off is a red flag.
After the two years are up
Once the two years pass, both parties can sell freely, and neither triggers the other's deferred gain. The restriction simply ends. You can even run another exchange with the same related party, which starts a fresh two-year clock.
The bottom line
Related-party exchanges are legitimate tools for family real estate planning, and the rules are clear: hold for two years, price the deal at arm's length, and disclose the relationship on Form 8824. The risk is not the rule but the mutual dependency it creates - your deferral now rides on someone else's decisions. Before proposing one, consult with a tax professional and confirm that both parties are fully committed to the two-year hold.
Related-party exchanges are legal but tightly regulated. The two-year holding rule ties your deferral to what the other party does, so careful planning and professional guidance matter before you start.
Frequently asked questions
Who counts as a related party under 1031 rules?
IRC 267(b) counts spouses, siblings, ancestors, and lineal descendants as related parties, along with entities in which you own more than 50% of the interest, including your own single-member LLC or a partnership you control.
What happens if a related party sells the replacement property within 2 years?
The deferred gain becomes taxable in the year of that sale, even though you held your own property. The rule binds both parties, so one person's sale can undo the other's deferral.
Can I buy from a related party or only sell to one?
The rules apply equally. If you are the buyer acquiring from a related party, both you and the seller must hold for two years.
Does the 2-year clock restart if we exchange again?
Yes. Once the first two-year period closes, you and the same related party can exchange again, which starts a new two-year clock without disturbing the earlier deferral.
What's the safest way to structure a related party deal?
Clean deals usually share four traits: an independent appraisal, documentation showing the terms are arm's-length, a qualified intermediary handling the funds, and a clear written understanding of the two-year commitment on both sides.