Dec
Article By: Jeff Skolnick, CPA, M.S. Taxation
Disallowance of Capital Gain Treatment
Generally, individuals enjoy certain tax benefits when selling or exchanging property. Among these benefits are capital gains treatment, installment sale reporting and the ability to report losses on these sales to name a few. The tax law has significant modifications to these general rules when the sales or exchanges are deemed to be between related parties. I will now highlight some of these modifications so that you can avoid accidentally falling into one of these traps.
The first thing to keep in mind is that the definition of “related party” is different depending on the trap we are discussing. For example, a sale between related parties that would otherwise be considered a capital gain (which if long-term have preferential income tax rates) may be taxed as ordinary income. This occurs if the property is considered to be depreciable property in the hands of the buyer. In my example I will use a rental property. Let’s say we have a Building with an original cost of $500,000. This building has $100,000 of accumulated depreciation and a Fair Market Value (FMV) of $700,000. Let’s further assume the building has been held for more than 1 year (qualifying it for long-term capital gain status). When the sale takes place the gain is calculated by taking the sales price of $700,000 less the basis of the property of $400,000 ($500,000 original cost reduced by $100,000 of accumulated depreciation) arriving at a gain of $300,000. Ordinarily the maximum tax rate on the first $100,000 of gain is 25%. This represents the gain attributable to the depreciation that had previously been taken. The remaining $200,000 would be considered long-term capital gain taxed at a maximum of 20%. Please also keep in mind that capital gains are considered investment income and may be subject to an additional 3.8% tax depending on your income.
If the sale is deemed to have taken place between related parties, then the entire $300,000 gain would be taxable at ordinary income tax rates which can be as high as 37%. Since this is such a dramatic difference in tax treatment it is important that we know who is considered a related party for this type of transaction. This transaction would be covered by Internal Revenue Code (IRC) 1239. This code section defines related parties as follows:
(1) a person and all entities which are controlled entities with respect to such person,
(2) a taxpayer and any trust in which such taxpayer (or his spouse) is a beneficiary, unless such beneficiary’s interest in the trust is a remote contingent interest (generally less than 5%), and
(3) in most cases, an executor of an estate and a beneficiary of such estate.
Controlled entities are generally, a corporation, partnership or LLC owned 50% or more by an individual or his/her spouse, siblings, parents, lineal ancestors and lineal descendants.
While I know that is very technical keep in mind any corporation, LLC or partnership owned 50% or more by you and/or your family defined above can trigger this situation. Also keep in mind this rule does not apply to individuals. If two individuals sell or exchange property, the rule will not apply even if the two individuals are related family members and therefore capital gain treatment is allowed.
Losses considered Nondeductible
When property is sold or exchanged between related parties, no loss is allowed on the transaction. Related parties under this trap are all of those listed under the previous example concerning disallowance of capital gain treatment and also include transactions with the family members previously discussed. The tax treatment to the buyer upon their sale of the property is also a little tricky as they may benefit from the loss disallowed. This is best explained by providing the example used by IRS Publication 544:
Example 1. Your brother sold stock to you for $7,600. His cost basis was $10,000. His loss of $2,400 was not deductible. You later sell the same stock to an unrelated party for $10,500, realizing a gain of $2,900 ($10,500 − $7,600). Your recognized gain is only $500, the gain that is more than the $2,400 loss not allowed to your brother.
Example 2. Assume the same facts as in Example1, except that you sell the stock for $6,900 instead of $10,500. Your recognized loss is only $700 ($7,600 − $6,900). You cannot deduct the loss not allowed to your brother.
Loss of the Ability to use the Installment Sale Method
Taxpayers often sell depreciable property (again we’ll use the example of a rental property) on an installment basis. Going back to our original example, let’s assume we sell a building for $700,000 with a cost basis of $400,000. This obviously yields a $300,000 gain. For purposes of this example we’re going to ignore the 25% vs. 20% income tax rates and discuss only the amount of income to be recognized and assume all is simply at long-term capital gains rates. The way an installment sale works is that a certain portion of each payment received is gain and a portion is return of principal. Let’s assume the buyer pays $210,000 in the year of the sale. The total sales price is $700,000 and the total gain is $300,000, therefore 3/7 of each payment is considered gain. The seller would realize gain on the $210,000 of $90,000 (3/7 of $210,000). Let’s further assume that the buyer will make payments of $70,000 in each of the following 7 years. The seller would pick up $30,000 of income in each of those years (3/7 of $70,000). The end result is the seller would pay tax on $300,000 but it would be spread over 8 years.
If the sale occurs between related parties (again we are using the definition supplied by IRC 1239) the seller would not be entitled to installment gain treatment and would have to pay tax on the entire $300,000 gain in the year of the sale (even though they only received $210,000). They would be no income tax on any payments received after the year of the sale so in both instances the taxpayer pays tax on $300,000, but obviously it is preferable to spread that tax over 8 years.
As you can imagine a taxpayer that does not discover this fact until March or April when filing their tax return can have an awful surprise.
Loss of Like-Kind Exchanges
Like-kind exchanges are exchanges of real property for real property. Once again, I will start with the general rule that in such an exchange no gain or loss is recognized, and the property received has the same tax basis as the property given up. There may be tax ramifications if money is also involved, however for purposes of this discussion assume both properties are of equal value. If two parties are deemed related (this time using the same rules as the loss disallowance trap), the nonrecognition treatment will be disallowed if the related party disposes of the property within 2 years of the original transaction.
Conclusion
As you can see there are significant traps that you should be aware of when selling or exchanging property with related parties. With proper planning some may be avoided, and some may not. Obviously planning that eliminates the problem totally is preferable but even if a situation cannot be avoided it is better to be aware of that before finalizing a deal with ramifications you did not account for. It is because of these traps that I urge you, as always, to consult with a tax professional well versed in this area of the law before selling or exchanging property with a related party.
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