Related Party Transaction Restrictions Under IRC § 179(d)(2) and § 168(k)(2)(E)(ii): What Real Estate Investors Need to Know

Investors and property owners often utilize cost segregation studies and accelerated depreciation strategies to maximize tax savings. However, the Internal Revenue Code (IRC) imposes restrictions on these benefits, particularly in transactions involving related parties. Understanding the nuances of IRC § 179(d)(2) and § 168(k)(2)(E)(ii) is essential to ensuring compliance and avoiding costly tax pitfalls.

Key Takeaways

IRC § 179(d)(2) and § 168(k)(2)(E)(ii) disallow Section 179 deductions and bonus depreciation for property acquired in a related party transaction as defined under IRC § 267 and § 707.

The TCJA of 2017 allowed bonus depreciation for used property but specifically excluded property acquired from a related party, preventing its use in parent-child or affiliated entity transactions.

Even if bonus depreciation is disallowed, cost segregation can help identify Section 1245 personal property that qualifies for shorter MACRS recovery periods (5- or 7-year) for tax savings.

If bonus depreciation is restricted, taxpayers can still utilize standard MACRS depreciation schedules or explore Section 179 deductions if they meet eligibility requirements.

Table of contents

• Key Takeaways
• What Are Related Party Transactions?
• IRC § 179(d)(2): Limiting Depreciation Deductions
• IRC § 168(k)(2)(E)(ii): Bonus Depreciation Restrictions
• Key Considerations
• How These Restrictions Impact Cost Segregation Studies
• Best Practices for Compliance
• Final Thoughts

What Are Related Party Transactions?

A related party transaction occurs when there is a transfer of property between entities or individuals that have a pre-existing relationship. The IRS closely scrutinizes these transactions to prevent tax abuse, such as artificially inflating depreciation deductions. Under the tax code, related parties include:

• Family members (spouse, siblings, ancestors, and descendants)
• Entities controlled by the same individuals
• Corporations, partnerships, or trusts with shared ownership interests

IRC § 179(d)(2): Limiting Depreciation Deductions

Section 179 allows businesses to expense the cost of qualifying property rather than depreciating it over time. However, IRC § 179(d)(2) restricts this benefit if the property is acquired in a related party transaction. Specifically, the deduction is disallowed if:

• The seller and buyer have a related party relationship as defined under IRC § 267 or § 707(b).
• The property was not primarily used in an active trade or business before acquisition.

For example, if a parent sells property to their child’s business and that business attempts to claim the full Section 179 deduction, the IRS may disallow the deduction.

IRC § 168(k)(2)(E)(ii): Bonus Depreciation Restrictions

Bonus depreciation under Section 168(k) allows taxpayers to immediately deduct a significant portion of the cost of qualifying property. However, IRC § 168(k)(2)(E)(ii) prohibits bonus depreciation on property acquired in a related party transaction.

To qualify for bonus depreciation, the buyer must show that:

• The property was not previously used by the taxpayer or a related party.
• The transaction does not fall under the related party rules outlined in IRC § 267 or § 707(b).

This prevents taxpayers from acquiring used assets from related entities and claiming immediate depreciation deductions that might otherwise be ineligible.

Key Considerations

Related Party Rules (§ 179(d)(2) and § 267/707)

• Bonus depreciation is generally not allowed on property acquired from a related party as defined in IRC § 267(b) and § 707(b).
• A parent-child relationship falls under IRC § 267(b)(1), making the transaction ineligible for bonus depreciation.

Used Property Exception Under TCJA

• The Tax Cuts and Jobs Act (TCJA) of 2017 allowed bonus depreciation on used property, but only if the buyer did not acquire the property from a related party.
• Since the father is a related party, the used property acquisition rule does not apply.

MACRS Classification and Recovery Period

• Cost segregation can still help identify Section 1245 personal property that qualifies for accelerated depreciation under 5- or 7-year MACRS recovery periods, even if bonus depreciation is disallowed.

Alternative Options

• If bonus depreciation is disallowed, the client can still take normal MACRS depreciation over the applicable class life.
• IRC § 179 deduction may also be an option if the taxpayer qualifies, but it is also subject to related party restrictions.

How These Restrictions Impact Cost Segregation Studies

Cost segregation is a powerful tax strategy that reclassifies building components to accelerate depreciation. However, if a property is acquired through a related party transaction, the benefits of cost segregation may be limited.

For instance, if a business purchases a commercial building from a related entity, certain assets may be ineligible for accelerated depreciation under Section 168(k). Similarly, any attempt to use Section 179 expensing may be disqualified due to the relationship between the buyer and seller.

Best Practices for Compliance

To maximize tax benefits while complying with IRS regulations, consider these best practices:

1. Understand Related Party Definitions – Before engaging in a transaction, determine whether related party rules apply.
2. Seek Independent Valuation – Obtain a third-party appraisal to substantiate the transaction’s fair market value.
3. Document Business Purpose – Maintain records showing that the property is used in an active trade or business.
4. Work with a Tax Professional – Consult with a cost segregation specialist and CPA to structure transactions appropriately.

Final Thoughts

Real estate investors can still leverage depreciation benefits even with related party restrictions. By carefully planning acquisitions and working with experienced tax professionals, investors can navigate IRC § 179(d)(2) and § 168(k)(2)(E)(ii) effectively. Cost segregation studies remain a valuable tool, but proper due diligence is essential to ensure compliance and optimize tax savings.

For expert guidance on cost segregation strategies and compliance with IRC regulations, reach out CostSegRx today!