You may have a client who comes to you with a “great idea” to sell their property to a family member at a loss in order to get a juicy tax deduction. Your client may ask the family member to resell it to them later, or maybe your client plans to just continue to use the land and keep it in the family. Unfortunately for your client, this is strictly forbidden by 26 U.S. Code § 267. This section of the code relates to sales within a family, some corporate sales, and some transfers between those involved with an estate.
26 U.S. Code § 267 specifically prohibits a deduction as the result of a loss from the sale or exchange of property “directly or indirectly” involving
- Members of a family, which is defined in subsection (c)(4) of the statute
- An individual and a corporation where the individual owns over 50% of the corporate stock
- Two corporations which are members of the same controlled group as defined under subsection (f)
- Various situations involving grantors, fiduciaries and beneficiaries of trusts or executors of estates as detailed in subsection (b) of the statute)
- An individual or organization and a Section 501 charitable educational and charitable organizations where the 501 is controlled by that individual or organization or member of their family.
- A corporation and a partnership if the same persons own—
- An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation
- An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation
The Effects of Constructive Stock Ownership Takes Some by Surprise
Some may try to get around this rule through a transaction where various family members own small percentages of corporate stock. This will not work. For purposes of the related parties rule, “An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family.” Subsection (c) of the code section gives more detail and situations where stock is considered to be constructively owned.
Indirect Transfers Won’t Circumvent the Law
Some people may sell property to a friend or other unrelated person they trust on the promise they will later sell it to a party related to the original owner. 26 U.S. Code § 267 still applies to that case, because it specifically mentions “indirect” transfers. The IRS will see what is going on and not allow the original party to declare a loss. And here’s the clincher. Even if the original seller sells the property to an unrelated party and that buyer does not resell it, if the IRS decides the price is way too low to have been an “arm’s length” transaction, they will still disallow the loss.
Are There Any Advantages to a Related Party Transaction?
Though it may at first glance appear there are opportunities for tax savings in related party transactions, the reality is they are usually bad for the seller and sometimes even for the buyer. The IRS will usually recognize gains, but it will not recognize losses.
When the related buyer, let’s call her Sister, resells at a profit, she will have to take the basis of the original seller, let’s call him Brother, not the lower price for which Sister bought the property. We have already seen that if Brother has a basis of $100,000 and sells to sister for $50,000, Brother cannot claim the $50,000 loss. However, if Sister later sells for $200,000, she will not realize a $150,000 gain but only a $100,000 gain, because she carries her brother’s basis.
However, if Sister takes a loss instead of a gain when she sells, then Sister can only deduct the difference between the amount for which she sold the property and the amount she actually paid for it. So, if Sister sells for $30,000, she can only take a loss for $20,000 not for $70,000. The money Brother lost on the sale to Sister will never be deducted by either Sister or Brother.
However, using a related party to purposely recognize a gain can be an affective way to utilize capital loss carryforwards. But be careful, because transactions between entities have special tax treatment.
Gain on Appreciated Property May Be Required to be Treated as Ordinary Income
Even when selling property at fair market value in an arm’s length transaction, sales between or to their closely held business can have difficult tax consequences.
There are three different tax rates faced when selling depreciable real property held for more than one year.
- There may be recapture which is taxed at ordinary income tax rates with a maximum rate of 35%
- Any unrecaptured §1250 gain is taxed at a maximum rate of 25%
- What remains is typically taxed at long term capital gains rate at a maximum rate of 15%
However, there are special rules that apply when property is sold or exchanged between related parties when it is depreciable property. I.R.C. § 1239 requires any gain recognized on this type of sale or exchange to be treated as ordinary income! In addition, even if the seller could not depreciate the asset, Rev. Rul. 60-302 applies to property that can be depreciated by the buyer.
In addition, under Treasury Reg. § 1.1239-1(a), the gain will be treated as ordinary income even when the purchaser decides not to depreciate the asset or chooses some other method of expensing such as amortization.
One additional thing to note is that these rules only apply to sales between related business entities. When depreciable property is sold at a gain between individuals, the special rules do not apply.