Author: Anonymous-122

Historically, real estate transactions were not uncommon amongst family and other related parties. Given this and prior history of taxpayers utilizing family or related parties to manipulate the existing IRS regulations on 1031 exchanges, Congress amended the code section to include Related Party rules in relation to 1031 exchanges. Due to today’s booming real estate market, it is even more popular for family to try to help the younger generation start their real estate investment journey, which makes it more important than ever to understand the Related Party rules outlined below. 
Background to the Related Party rules
Tax deferral under section 1031 of the U.S. tax code is very taxpayer-friendly, potentially allowing taxpayers to defer capital gain, depreciation recapture, healthcare tax, and state tax.   However, to take advantage of this code section, taxpayers have to play fair and strictly follow the rules.  In the past, it was possible to manipulate the rules to achieve a favorable outcome by bringing a party related to the taxpayer into the transaction. In 1989, Congress amended the code section to stop this abuse. The amendment prohibits taxpayers from entering into transactions with related parties, subject to a few limited exceptions. According to the legislative history of §1031(f) “if a related party exchange is followed shortly by a disposition of the property, the related parties, have in effect, cashed out of the investment.”
This new section, 1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 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”
What was the abuse that gave rise to the Related Party rules?
Take as an example “Parent Company” which has Property A for sale with a lot of built-in gain and no need to acquire a replacement property.  Its affiliate, “Subsidiary Company” owns Property B of similar value with a high basis. In any exchange, the basis is carried over from the relinquished property to the replacement property.  So rather than sell the properties outright, the two companies enter into an exchange with one another to defer taxes.  Parent Company holds Property B indefinitely, but shortly after the exchange, Subsidiary Company sells Property A.  Since Subsidiary Company has a high basis in Property A, there is little tax effect to it upon the sale.  This was a common occurrence prior to the 1989 Related Party rules addition to section 1031.
Can any part of a taxpayer’s exchange transaction involve a related party?
Often a taxpayer will sell the relinquished property to a related party while acquiring replacement property from an unrelated party.  This structure is not prohibited by the Related Party rules since it does not involve the taxpayer carrying over tax basis into the property sold (it is carried over into the property being purchased), and therefore there is no opportunity for the tax abuse that the rules seek to curb.  Between 2007 and 2010 there were a series of