More Related Party Exchange Guidance

Who are related parties? Related parties include –

• Members of a family (including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors, and lineal descendants).
• An individual and a corporation, partnership or LLC when the individual owns, directly or indirectly with family members, more than 50% of the ownership of each corporation, partnership or LLC.
• Two corporations, partnerships or LLCs when the same person or owners own, directly or indirectly with family members, more than 50% of the ownership of each corporation, partnership or LLC.

If a related party is used in this fashion, it is preferable to use a party or entity which already exists that is not just a shell entity set up to do this transaction (with the entity disappearing after the relinquished property is sold). The related party should bear the benefits and burdens of ownership of the relinquished property and not be merely acting as the taxpayer’s agent. The purchase price of the relinquished property should be fair market value.

When the property is resold by the related party, the gain or loss may be short term if the property has been held for less than 12 months by the related party. So, care should be taken to price the sale to the related party at the expected property sales price.

Potential ordinary income from sale to a related party. Sale of depreciable property to a related party. Under IRC §1239(a) any gain from the sale of depreciable property to a related party is ordinary income rather than capital gain. In the context of a 1031 Exchange, if there is any boot to be reported by the taxpayer from a sale of the relinquished property to a related party, the boot will be taxed as ordinary income.

Sale of property to a corporation by a shareholder. Under case law, if a shareholder sells his property to a related party corporation (51% or more of ownership) and if a subsequent resale by the corporation would be treated as ordinary income by the corporation, the gain on the sale by the shareholder to his corporation will also be ordinary income (and not capital gain). However, even if the related party is a corporation, only boot received by the taxpayer will be taxed as ordinary income. Just to be on the safe side, it is better for the related party or entity to be a person, LLC or partnership and not a corporation.

If you would like further information about 1031 exchanges between related parties, further guidance is available on our website at our Related Party Rules section.