Disallowed Losses - Sales to Related Parties
This year the stock market and the real estate markets have been strong. As we get to the end of the year, investors start looking for losses to claim. From time to time, we have had the difficult task of explaining to clients who felt they had "developed" the perfect plan to gain a tax deduction by selling a piece of property at a loss to a relative. But it does not work - I.R.S. Code Sec. 267 specifically disallows losses on sales to related parties.
Congress felt there is simply too huge a potential for abuse. Family members could continually “sell” property between themselves at a loss until all losses are realized. For example, Taxpayer A owns a farm that he inherited from his uncle and has no intention of ever allowing it to leave the family. His inherited basis in the property is $300,000, but he decides to "sell" it to his brother for $200,000 and thereby, gain himself a $100,000 tax write-off. After several years, his brother "decides he no longer wants it" and sells it back to Taxpayer A for, now, $100,000 gaining himself a $100,000 write-off, also! Those losses are strictly disallowed.
It does not matter that the asset is being sold for its actual fair market value. And the Tax Court has ruled that family hostility may not be considered; losses between proscribed family members are disallowed in all cases.
Section 267 not only applies to family members, but also includes related businesses, trusts, fiduciaries, etc as defined:
Members of a family, including brothers and sisters, spouse, ancestors (e.g., parents, grandparents), and lineal Descendants (children, grandchildren).
An individual and a corporation where more than 50% of the stock is owned directly or indirectly by that individual. (Indirectly means, for example, that stock owned by your children can be deemed owned by you.)
Two corporations which are members of the same controlled group (e.g., common ownership).
Certain relationships between trusts, grantors, fiduciaries and beneficiaries of such trusts.
A corporation and a partnership if the same persons own more than 50% of the stock of the corporation and more than 50% of the profits or capital interest of the partnership.
An S corporation and another S corporation if the same persons own more than 50% of the stock of each corporation or an S corporation and a C (regular) corporation if the same persons own more than 50% of the stock in each.
Even if you actually own less than 50%, for the purpose of this rule, you may be held to own all the stock that your family members own. This is known as the "constructive ownership rule."
There are related parties other than the ones listed above as well. What exactly constitutes a related party can sometimes be a gray area and you should certainly contact us first if you think there may be some risk to a particular transaction you are planning.
We advise our clients to avoid related party transactions at all times if possible. Gains and losses on related party transactions cannot be netted. The gains on a related party transaction are generally recognized, but losses are not; all of the "gain" items are added up and reported on your tax return, but all of the "loss" items are not.
Also, the disallowed loss on a related party transaction isn't always recaptured upon a subsequent sale by the other party. For example, if you own shares of Company X with a $20,000 basis and you sell those shares to your sister for $10,000, you obviously cannot take the $10,000 loss you incurred under the related party rules. If your sister then sells the shares for $30,000, she will recognize only the $10,000 gain between your $20,000 basis and her $30,000 proceeds. (Provided she is aware of these rules and gets and keeps your records.)
However, if she later sells the shares for only $5,000, her loss will only be the difference between the $10,000 she paid you and the $5,000 in proceeds. The $10,000 you lost on the sale to her will never be deducted by either of you!
Indirect sales will not work either: for example, sell a piece of property to an unrelated party (a non-relative friend) who then turns around and re-sells the property to your related party. Sec. 267 also applies to "indirect" transfers. The I.R.S. can simply "look through" the transaction and disallow the loss.
And what happens if the friend in the example above doesn't re-sell the property to a related property? Well, the related party rules can still bite you if the I.R.S. deems that the price appears to be artificially low and could not reasonable have been an "arm's length" transaction. Yes, even friends can be related parties if the deal looks suspicious.
As you can see, there are a lot of "traps" in the related party rules. We encourage you to call our office if you are considering a transaction that could even remotely be considered a related party transaction.