Are you considering selling your property to a family member or lending money to your niece for her wedding? Sometimes, a transaction between you and your relative can be favorable for both of you, including lower rates and thus lower taxes on the income. However, there are several things that are worth considering before getting involved with a related party.
Transactions between related parties, such as family members, can include sales and exchanges of property and loans. Even if the sale is completed at arm’s length, the IRS still sees it as a related party transaction, and thus it is subject to the loss disallowance rule. Additionally, the IRS requires that loans between family members be structured like any other loan.
In a related party sale or exchange, the taxpayer is not allowed to deduct a loss. Disallowing a loss on the sale or exchange of property between related parties acts as a deterrent to entering into transactions that have no real economic substance except to avoid tax. This disallowance rule has been upheld by the U.S. Supreme Court. There is no real economic substance if the property is obsolete or the property is sold only in name when in fact ownership is still retained in the family or economic unit.
However, as with every rule, there is an exception. If the buyer sells the property to an unrelated third party, the amount of gain recognized on the subsequent sale can be reduced by the amount of the loss disallowed in the previous sale.
Another transaction that is looked at closely by the IRS, is a loan between related parties. The IRS requires that these loans be structured like any other loan. The rate cannot be lower than the going market rate. The IRS publishes the Applicable Federal Rate (AFR) each month, which serves as the minimum acceptable interest rates for most loans.
If the loan terms are too favorable, such as when the interest rate is deemed lower than the AFR, the IRS can recharacterize that loan as something else, such as a gift, which has different tax implications. The loan might also be subject to below-market loan rules, which means that the lender and the borrower are required to recognize interest income and interest expense based on the relevant AFR rather than on their agreed actual interest rate, for federal tax purposes.
Related party transactions can have unintended tax consequences and the definition of a related party is confusing and detailed. If you think you might be in the category of a related party transaction, or are looking to make such a transaction in the future, we suggest that you are thorough and seek counsel beforehand. If you have any questions regarding this or any other tax matters, please do not hesitate to contact your L&B professional at (858) 558-9200.