What is the Two-Year Rule for 1031 Exchanges?

While all like-kind exchanges are subject to specific requirements under Section 1031 of the Internal Revenue Code, certain types of exchanges are subject to more requirements than others. These include exchanges between “related persons.” In related-party transactions, a special two-year rule applies, and failure to comply with this rule can trigger immediate federal tax liability. Learn more from an experienced 1031 exchange intermediary:

What is a “Related Person” for Purposes of a 1031 Exchange?

The two-year rule under Section 1031 applies specifically to exchanges involving “related persons.” Under subsection 1031(f)(3), “related persons” can be any of the following:

• Family members
• The owner of 50 percent or more of a corporate entity conducting a 1031 exchange
• Two business entities if the same person owns more than a 50 percent interest in each business
• Corporations that are members of the same “control group” (as defined in Section 267 of the Internal Revenue Code)
• The grantor and fiduciary of a trust
• The beneficiary and fiduciary of a trust
• The beneficiary and executor of an estate (“[e]xcept in the case of a sale or exchange in satisfaction of a pecuniary bequest”)

This list is not exhaustive. If you have questions about whether the parties involved in a proposed 1031 exchange may qualify as “related persons,” this is an issue that you will want to discuss with a 1031 exchange intermediary early in the process.

What is the Two-Year Rule for Related-Party Exchanges?

When related parties conduct a like-kind exchange, they must comply with the two-year rule in subsection 1031(f)(1). This rule provides that, in most circumstances, “there shall be no nonrecognition of gain or loss” under Section 1031 if:

“[B]efore the date two years after the date of the last transfer which was part of such exchange—(i) the related person disposes of such property, or (ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer . . . .”

In other words, if either of the related parties involved in a 1031 exchange sells the property it acquired during the exchange within two years of the exchange, then like-kind exchange treatment under Section 1031 is disallowed. If this happens, any deferred tax liability related to the like-kind exchange becomes immediately due and payable to the Internal Revenue Service (IRS).

Importantly, while this is the general rule, there are a few exceptions. For example, the two-year rule does not apply in the event of the death of either of the related parties. It also does not apply in the case of “compulsory or involuntary conversion” (i.e., destruction, seizure or condemnation), or when the parties involved in the exchange “establish[] . . . that neither the exchange nor such disposition had as one of its principal purposes the avoidance of federal income tax.”

What Are the Consequences of Violating the Two-Year Rule?

Let’s say you conduct a like-kind exchange with a related party and then one of you subsequently violates the two-year rule. What are the consequences?

As discussed above, violating the two-year rule creates immediate liability for any tax triggered by the like-kind exchange. If you pay this tax on time, this is most likely all that you will owe (though you could potentially face additional penalties if the IRS accuses you of intentional tax fraud). However, if you do not pay on time, you could face additional liability for:

• Interest on your delinquent tax liability;
• Accuracy-related penalties; and,
• Additional civil or criminal penalties depending on the circumstances involved.

Generally speaking, these are the same penalties that apply when like-kind exchange treatment is disallowed for other reasons. With these risks in mind, it is critical to ensure compliance with all pertinent provisions of Section 1031. This includes ensuring compliance with the two-year rule for related-party exchanges. An experienced 1031 exchange intermediary can assist you with meeting all pertinent requirements and documenting compliance with Section 1031 so that you are prepared to withstand scrutiny from the IRS if necessary.

Discuss Your Exchange with an Experienced 1031 Exchange Intermediary in Confidence

Do you have more questions about the requirements for securing an indefinite tax deferral through a 1031 exchange? If so, we can explain everything you need to know, and we invite you to get in touch. To schedule a call with an experienced 1031 exchange intermediary at 1031 National Services, give us a call at 888-872-1031 or request a free consultation online today.