The vast majority of professionals misunderstand the rules that govern the IRC section 1031 tax-deferred trading, so it is really not surprising that ordinary business owners get easily confused. The 1031 exchange implies the trade of like-kind real estate and it must be noted that this trading applies solely to real estate. If you want to avoid paying capital gains tax, you have no other option than to enter in a section 1031 exchange. However, it is essential to pay attention to the fact that a real estate tax exchange is governed by a number of rules. In order to prevent abuses, the government has introduced a set of rules for taxpayers. The rules are very strict when it comes to transactions between related parties.

Like-kind exchanges in general

Like-kind exchanges broadly refer to substituting a similar business or investment with one of the same kind and the great news is that the gain is not recognized until the relinquished real estate is sold. The word like-kind refers to the nature of the property. For instance, you cannot swipe a hotel with a business vehicle. As long as the nature of the assets is the same, the quality does not really matter. What is important to stress is that if the trade takes place between related parties, the gain will be recognized in about two years. Naturally there are exceptions to the rule, but they are not very common.

What are the related party rules

As mentioned before, there are strict rules when it comes to related parties. The term related party refers to a family member, such as a spouse or an ancestor. Once the IRC discovered that the vast majority of transactions were carried out only with the purpose to gain an advantage and consequently avoid responsibility, it made the penalties a lot tougher. According to the rules, you have to hold the real estate for a period of two years in order to be eligible for the non-recognition treatment. This is the minimum holding period. The good news is, however, that there are exceptions to the rule. For example, if you can prove that your intention is not to avoid paying capital gains tax, then you have a real shot at not being disallowed.

Use a qualified intermediary to not provoke the related party prohibition

What most investors do is resort to using a qualified intermediary, or a QI, to facilitate the transaction. What happens is that you sell the real estate to a third party and thus the prohibition is nullified because you do not technically enter in the related party exchange. It is important to keep in mind, however, that you need to be very careful when taking action as nothing can save you from being penalized. The bottom line is that the rulings are scrupulous and you do not want to be accused of tax avoidance or tax evasion. When purchasing from a family member, things are always complicated and this is the reason why you should be very careful when it comes to federal income tax.