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How to Tell When Related-Party Rules Apply


Clients who are considering selling investments to related parties should be aware of how and when the rules apply. Tax guru Julian Block explains some of the rules, such as when it pays to buy a relative's investment loss, and when it doesn't.

Mar 31st 2022
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This is the second part of a two-part series on related-party sales. If you're just joining us, go back and read part one to learn about how Section 267 defines an investor's related parties and important exceptions to the rule.

What happens when an investor passes the loss on. Sometimes, a disallowed loss can be salvaged, as when a related buyer resells at a profit.

Let’s say an investor buys 100 shares of DEF Company for $10,000 that she later sells to her brother for $8,000. Generally, she can’t deduct her $2,000 loss. This holds true even though she made the sale “in good faith,” that is, without intending to avoid taxes.

When does related-buyer brother get the benefit of the disallowed loss? When he realizes a profit on the sale of his DEF shares. His profit escapes taxes up to the amount of the original investor’s loss.

The brother’s basis for the DEF shares is the $8,000 that he paid his sister. If he sells them for $11,000, making his gain $3,000, then he’s liable for taxes on only $1,000 of the gain ($3,000 minus the $2,000 disallowed loss).

This break benefits only the brother. It’s unavailable to a subsequent purchaser.

Is the gain long-term or short-term? It depends on how long the original investor held the share.

What happens if he sells his shares for $7,000? His loss is $1,000. He can’t deduct the loss that the IRS wouldn’t allow his sister, the original investor.

No break for family feuds. The related-party rules apply even in the event of a family fight. This was underscored by a Tax Court decision that disallowed a capital loss for a sale between two brothers that was ordered in binding arbitration that separated the brothers’ stock and real estate holdings.

Sometimes, the IRS makes exceptions. In one case, the IRS allowed an estate to claim a loss from the sale of real property to the decedent’s daughter. The estate was unable to find a buyer for the property, and the property was sold at a loss, on behalf of the estate, to the daughter, who was a co-executor for the estate. The IRS said that the creation of an estate wasn’t the result of the same “forethought” as a trust, which can be set up specifically to reduce taxes.

I remind clients that even when the related-party rules are inapplicable, the transaction must be bona fide. The IRS can still disallow the loss if it determines that the primary motive for a sale was tax avoidance.

Beware of multi-asset sales. Related-party sales can cause other complications. When the sale includes a number of blocks of stock or pieces of property, the IRS measures gain or loss separately for each asset sold––not by the overall result of the sale. Thus, even if a lump-sum sale results in a net loss for an investor, she may have a taxable gain if the IRS disallows the losses on some of the assets involved.

Let’s say she owns over 50 percent of the stock of Geneva Enterprises. To satisfy part of a debt to Geneva, she gave the company $65,000 worth of stock that she owned in a publicly held corporation. As a result of the transfer, she incurred a $1,000 loss.

But by figuring the profit or loss separately on each block of stock she had purchased (at different times and at different prices), the IRS computed total losses of $10,000 and total gains of $9,000. Since the sale was between related parties, the $10,000 loss was disallowed, and she wound up with a taxable gain of $9,000.

What should she have done to avoid this unfavorable tax result? Sell her loss stock on the market and give the proceeds to Geneva, that way, she would’ve wound up with a $10,000 deductible loss to offset her $9,000 gain.