A related party exchange, also known as a related party transaction, refers to a like-kind exchange of property between parties who have a pre-existing relationship or connection. In the context of Section 1031 of the Internal Revenue Code, a related party exchange involves the exchange of property between individuals or entities that are considered related under the tax law.
Under Section 1031, related parties include:
Family members: This includes spouses, siblings, parents, children, and other relatives as defined by the tax law.
Entities with common ownership: This includes corporations, partnerships, and other entities in which the exchanger owns more than 50% of the ownership interest, either directly or indirectly.
When engaging in a related party exchange, there are specific rules and limitations that apply to ensure the transaction is conducted in a manner consistent with the tax code. These rules are designed to prevent abuse and ensure that the exchange is conducted at fair market value.
One important rule is the two-year limitation rule under Section 1031(f)(1). This rule requires that if either the party who transferred the property or the party who received it disposes of the property within two years after the exchange, any gain or loss on the original exchange must be recognized for tax purposes. This means that the tax consequences of the exchange are triggered if the property is disposed of within the two-year period.
It’s important to note that related party exchanges are subject to additional scrutiny by the IRS to ensure compliance with the tax law. The IRS may closely examine the transaction to determine if it is a bona fide exchange conducted for valid business or investment purposes, rather than solely for tax avoidance.
Engaging in a related party exchange requires careful planning and consideration of the specific rules and limitations that apply. It is advisable to consult with tax professionals or attorneys experienced in like-kind exchanges and related party transactions to ensure compliance with the applicable regulations and to address any specific circumstances or complexities in your situation.