When Does It Pay to Buy a Relative's Investment Loss?

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In a previous column, I covered some of what can happen when Section 267s disallows loss deductions for sales to certain family members and other related parties. The IRS says verboten relationships include a shareholder and a corporation of which the shareholder owns more than 50 percent.

I’m devoting this column to explain other kinds of tax tribulations that kick in when there are multi-asset sales. When the property sold in one transaction consists of 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.

What happens when a multi-asset sale results in a net loss? The Stepford response of the IRS is to create a taxable gain simply by disallowing losses that were sustained on some of the assets involved. Result: The taxable gain may far exceed the net dollar gain from the sale.

Consider, for example, Klaus, the owner of over 50 percent of the stock of Geneva Enterprises. To satisfy part of a debt to Geneva, he plans to give it $65,000 worth of stock he owns in a publicly-held corporation. Klaus concludes that the net result of the transfer to Geneva will be that he reaps a loss of $1,000.

I caution Klaus that the IRS is going to read the rules differently. It will figure the profit or loss separately on each block of stock he had purchased at different times and at different prices, resulting in total losses of $10,000 and total gains of $9,000. Because the sale is between related parties, it will disallow the $10,000 loss. He should expect to be billed for taxes, interest and penalties on a gain of $9,000.

Klaus beams when I explain that there’s an easy, IRS-blessed way for him to sidestep this unfavorable tax result. Klaus should sell his loss stock on the market and give the proceeds to Geneva. Going that route will entitled him to offset a $10,000 loss against a $9,000 gain.

When it pays to buy a relative’s investment loss: Amidst all the thorns, there’s a rose. A loss disallowed under Section 267 isn’t forfeited forever. It becomes available to the purchaser when the purchaser later disposes of the property at a gain.

Why? The law requires recognition of gain only to the extent it exceeds the disallowed loss.

An example: High-bracket George is the son of zero-bracket Lennie, someone with a laundry list of ailments and the recipient of some income from dividends and a modest pension. All of Lennie’s income escapes being taxed because his medical expenses and other itemized deductions on Schedule A are sufficiently high to reduce his taxable income to zero.

Lennie derives his dividend income from 1,000 shares of Lady Godiva Accessories (LGA) that he acquired for $15 a share. LGA now sells for $5 a share. Were Lennie to sell on the open market, his deductible loss of $10,000 wouldn’t save him a penny in taxes.

My advice to Lennie: It would be a tax-savvy move for him to sell the shares to George. Lennie should disregard Section 267’s disallowance of his loss and think of himself and his son as a family unit when it comes to taxes.

Why? Because George will buy at $5 a share, his gain can’t be taxed until he sells for more than $15.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 300 and counting). 

About Julian Block

Julian Block

Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes” (Wall Street Journal), and “an authority on tax planning” (Financial Planning magazine). More information about his books can be found at julianblocktaxexpert.com

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