Exchanges of like-kind property between related persons are subject to special rules. Related persons include members of your family, corporations and partnerships in which you have more than 50% ownership. If either party disposes of the property within 2 years after the exchange, the exchange does not qualify as a nontaxable exchange and any gain or loss on the original exchange would have to be recognized (reported for tax purposes) at the time of disposing of the property received in exchange.
Example
You and your brother both have rental properties that you use for the production of income. You decide to exchange certain rental properties. At the time of the exchange, the fair market value of your property was $80,000. You originally paid $60,000 for it and have claimed depreciation of $40,000. Your brother’s rental property has a fair market value of $82,000. He paid $65,000 for it and has claimed $35,000 in depreciation. You give your property plus $2,000 in cash in exchange for your bother’s property. Less than 2 years after the exchange, you sell the property you received in the exchange to a third party for $85,000.
You realized a gain of $64,000 on the exchange ($82,000 fair market value of the property you received plus $2,000 cash you paid, minus your adjusted basis of $20,000 in the property you gave up).
Your brother realized a gain of $52,000 ($80,000 fair market value of the property he received, plus the $2,000 cash you paid, less his adjusted basis of $30,000 in the property he gave up).
Since this was a nontaxable, like-kind exchange at the time, you did not recognize any gain for tax purposes, and your basis in the property you received is your basis in the property you gave up, $20,000, plus the $2,000 you paid in cash, for a total of $22,000.
Your brother recognized gain on the exchange only for the $2,000 he received from you in cash. His basis in the property he received is his adjusted basis in the property he gave up, $30,000, minus the $2,000 cash received, plus the gain of $2,000 that was recognized, for a total of $30,000.
When you sell your property within 2 years, the exchange is disqualified as a nontaxable exchange.
You would have to recognize your gain of $64,000 on the exchange, and a gain of $63,000 on the sale of the property ($85,000 realized on the sale minus your adjusted basis of $22,000).
Your brother would also have to recognize the rest of his gain from the exchange (total realized gain of $52,000 less $2,000 recognized gain), and his basis in his property would be increased to $80,000 ($30,000 basis from the exchange plus $50,000 additional gain recognized).