Due to the opportunity for abusive transactions between related parties, the IRS generally does not allow a taxpayer to take a tax loss on a sale of property to a related party.
The problem
Suppose Carl has a vacation home on a lake. He invites his extended family there for holidays and summer vacations. Carl has no children of his own, and when he dies he leaves the property to his favorite nephew, Seth. Seth gets the property with “stepped-up” tax basis – the fair market value of the property at the date of Carl’s death (or the alternate valuation date six months later). In this case, the fair market value is $450,000.
A few years later, Seth has some big capital gains and is looking at a big tax bill. He comes up with a great idea. He can sell the property to his brother Andy for $350,000 and take a $100,000 tax loss for himself ($350,000 proceeds – $450,000 basis = $100,000 loss).
And heck, Andy might as well hold the property for a year or two and then sell it back to Seth for $250,000, giving himself a $100,000 loss and getting the property back to Seth.
Losses disallowed on sales of property to related party
Hopefully Seth runs this idea past his tax advisor before going through with it, because IRC §267(a)(1) states that “no deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between [related parties].”
Related parties for this purpose include the following:
- Ancestors (parents, grandparents, etc.)
- Lineal descendants (children, grandchildren, etc.)
- Spouses
- Brothers and sisters
- An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual
- A partnership and a person who owns, directly or indirectly, a more than 50% capital or profits interest
- Various relationships between fiduciaries, trusts, grantors, and beneficiaries
- C corporations, S corporations, and partnerships which have greater than 50% common ownership
Result of a related-party sale at a loss
Unfortunately Seth and Andy go ahead with the sale before consulting their tax advisors. When tax return time comes, Seth learns that he cannot claim the $100,000 loss he was expecting. So, what happens to the loss? It depends on what Andy does with the property.
Sale to a third party at a gain
Andy gets the property with basis of $350,000 (the amount he paid for the property).
Suppose Andy holds the property for several years and the property appreciates. He sells it to an unrelated third party for $500,000.
The gain on the sale is $150,000 (proceeds of $500,000 – Andy’s basis of $350,000 = $150,000 gain). However, Andy gets “credit” for Seth’s disallowed loss of $100,000. So, Andy only reports a taxable gain of $50,000 on his tax return.
Note that Andy gets the benefit of Seth’s disallowed loss. Seth gets no benefit from the transaction.
Sale to a third party at a loss
Now suppose that Andy holds the property for several years but it loses value. Andy sells the property to an unrelated third party for $300,000.
The loss on the sale is $50,000 (proceeds of $300,000 – Andy’s basis of $350,000 = $50,000 loss).
In this case, Andy does not get credit for Seth’s previous disallowed loss. Neither does Seth. No one does. The $100,000 disallowed loss is lost for good. Andy reports a taxable loss of just $50,000 on his tax return.
Other considerations
Sale to another relative
A bona fide sale to a niece, in-law, or other relative not specified in the §267 rules can generate a tax loss. However, the IRS is more likely to scrutinize such a sale. Be prepared to provide solid evidence that the purchase price was indeed the fair market value of the property.
Gains on related party sales
A gain on a sale to a related party is taxable. It’s only losses that are restricted.
Constructive stock ownership
For purposes of the 50% ownership test above, an individual is treated as owning the stock owned by family members. For example, if two parents and two children each own 25% of a corporation’s stock, they’re each treated as owning 100% of the stock.
Sales of multiple properties
You can’t get around the loss disallowance rules by selling several properties, some at a gain and some at a loss. The gains and losses can’t be netted. The gain transactions will result in taxable gain, but the losses will not be allowed.
As always, please consult your tax advisor, and feel free to leave a comment below!
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