Doing business with related parties can be accomplished but it takes some additional planning and due diligence. Holding periods are carefully monitored both before and after an exchange takes place. The reasoning behind the restrictions is due to the opportunity to shift tax basis with closely held entities or families thereby creating tax avoidance.
Section 1031(f) provides special rules for property exchanges between related parties. A taxpayer exchanging like-kind property with a related person cannot use the provisions of 1031 if, within 2 years of the date of the last transfer, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. The taxpayer takes any gain or loss into account in the taxable year in which the disposition occurs. The two year rule is in essence a “safe harbor”.
For purposes of Section 1031(f), the term “related person” means any person bearing a relationship to the taxpayer described in Sections 267(b) or 707(b)(1). Plainly said, related parties include, but are not limited to, immediate family members, such as brothers, sisters, spouses, ancestors and lineal descendants’. However, related parties do not include stepparents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.
Corporations, limited liability companies or partnerships in which more than 50% of the stock, membership interests or partnership interests, or more than 50% of the capital interests or profit interests, is owned by the taxpayer is considered to be a related party.
Disposition (Sale) to a Related Party
It is clear that a taxpayer can dispose of (sell) his or her relinquished property to a related party and acquire like-kind replacement property from a non-related party without violating the related party rules and guidelines. The related party must hold the relinquished property acquired from the taxpayer for a minimum of two (2) years, and the taxpayer must hold the replacement property acquired as part of the 1031 Exchange for a minimum of two (2) years in order to qualify for tax-deferred treatment.
Acquisition (Purchase) from a Related Party
However, it appears that you may not be able to dispose of (sell) relinquished property to a non-related party and acquire like-kind replacement property from a related party without recognizing depreciation recapture and capital gain income tax liabilities.
However, you are generally entitled to defer income tax liabilities when you purchase property from a related party and your related party is also completing their own 1031 Exchange transaction using the sales proceeds from your purchase of the related party’s property, or if you can prove that the transaction did not result in an income tax basis swap (tax avoidance).