To address a very common question regarding 1031 exchanges, the question comes up that: Can I do a 1031 exchange and purchase the replacement property from a relative or from an entity that I hold some interest in?
Well, selling a property to a related individual is, generally, not an issue with the IRS, however, it is an issue when you purchase the replacement property from someone you’re related to. The Internal Revenue Code, specifically section 267B, defines what it considers a related person. While the said section, definitely, talks about its objection to various relationships, such as siblings, spouses, mothers, and fathers but it does not address what relationships it considers exempt.
When it comes down to entities that you may have an interest in, the IRS does not allow taxpayers to purchase replacement properties from entities that the taxpayer holds a 50% or more interest in, if you as the taxpayer hold an interest of, let’s say, 60% in an entity that owns a replacement property in Austin, Texas that you intend on purchasing, the IRS believes that you could, as the majority shareholder in the entity, can easily rig the transaction to favor yourself as the taxpayer engaging in the 1031 exchange.
On the other hand, if you are a minority shareholder with multiple other members of the entity that hold an interest in it, the IRS sees you as not having major power in the entity to be able to rig the transaction in your favor, thus, the IRS does not have an issue with if you are a minority shareholder holding less than 50% in the entity that owns the replacement property, be it in Austin or Houston, Texas, that you intend on purchasing.
Now if you are a 20% shareholder in an entity that owns a replacement property in San Antonio, Texas that you intend on purchasing, and the other 80% shareholder is your spouse, sibling or parent, the IRS will have an objection to the said arrangement and may invalidate your exchange.
In conclusion, it is best to purchase replacement property from unrelated parties and/or entities that you are not a part of in order to avoid unnecessary scrutiny from the IRS.