---
title: What is a Related Party Transaction?
description: In this article we’ll look at related party transactions and what could potentially happen when related parties conduct real estate transactions.
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---

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# What is a Related Party Transaction?

Posted Feb 19, 2023

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In 2021, when interest rates remained at historic lows, there were a record number of residential real estate transactions. The total number of residential home sales exceeded 7.2 million, and the value of all those transactions topped $2.8 trillion.1 

Safe to say the vast majority of those sales were arm’s-length transactions conducted between unrelated parties. Related party transactions – sales occurring between two parties that have pre-existing relationships prior to the close of sale – can trigger unexpected tax consequences. 

In this article we’ll look at related party transactions and what could potentially happen when related parties conduct real estate transactions. 

### Defining Related Parties 

A full legal definition of related party transactions can be found in Internal Revenue Code (IRC) 1239.2 

Transactions that occur between parties that have certain pre-existing business or familial relationships prior to the deal taking place are considered related parties. It’s a common occurrence, but the nature of the relationship can significantly impact your financial position in the deal.  

For business entities, a related party is typically defined as any company director, executive officer shareholder who owns more than 5 percent of the company's voting securities, as well as any of their family members. For individual taxpayers, related parties are immediate family members, including children and stepchildren, parents or stepparents, spouses, siblings, and in-laws (parents, sisters, brothers). Additionally, the related party definition extends to people sharing a household with these relationships.3 

### Tax Treatment of Related Party Transactions 

The gist of what investors or property owners should know about tax treatment on transactions between related parties is this: When real property is directly or indirectly exchanged between related parties, any gain recognized by the seller will be treated as ordinary income if the property was subject to depreciation. 

It’s an extremely important item to note, because any realized capital gains, as well as depreciation claimed, will be taxed as ordinary income instead of the more favorable capital gains tax rates of 0, 15, or 20 percent depending on your filing status and income.  

Here’s an example: 

You purchased an investment property for $300,000, and you’ve claimed $50,000 in depreciation deductions over the years you held the asset, resulting in a cost basis of $250,000. If you sell the asset to a related party for $500,000, the property’s current fair market value, you will generate a gain of $250,000. Since this is a sale between related parties, instead of being taxed as capital gains, the $250,000 of gain will be taxed at your nominal tax rate, which could be as high as 37 percent. 

### Putting it all Together 

Normal tax advantages enjoyed by real estate investors are suspended in transactions that take place between related parties. These sales may result in a negative taxation or financial position for sellers since any realized capital gains and depreciation deductions will be reclassified as ordinary income and subject to the taxpayers nominal tax rate rather than the more favorable long-term capital gains rate (0, 15, or 20 percent). Related party transactions also take the possibility of conducting a 1031 exchange off the table, since the taxpayer has no realized capital gains to defer. 

Consulting with an experienced tax advisor prior to conducting a real estate transaction could help eliminate costly missteps, especially if the buyer may qualify as a related party or someone with whom you have a pre-existing business relationship.

1 2021: A Record-Breaking Year for Real Estate Transactions, Corelogic, [https://www.corelogic.com/intelligence/2021-a-record-breaking-year-for-real-estate-transactions/](https://www.corelogic.com/intelligence/2021-a-record-breaking-year-for-real-estate-transactions/) 

2U.S. Code 1239 – Gain from sale of depreciable property between certain related taxpayers, Cornell Law School, [https://www.law.cornell.edu/uscode/text/26/1239](https://www.law.cornell.edu/uscode/text/26/1239) 

3Related Party Transaction Policy, Securities and Exchange Commission, [https://www.sec.gov/Archives/edgar/data/1437517/000101054917000418/ex142.htm](https://www.sec.gov/Archives/edgar/data/1437517/000101054917000418/ex142.htm) 

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Hypothetical examples shown are for illustrative purposes only.

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