Introduction
Purpose of the Article
In this article, we’ll calculate gain or loss on sale to unrelated third party from related party. Understanding how to calculate gain or loss on the sale of property by a related party to an unrelated third party is essential for anyone involved in tax planning and compliance. Related party transactions, as defined by the Internal Revenue Code (IRC) Section 267, are subject to special rules aimed at preventing tax avoidance. When property is sold between related parties, the tax treatment of the transaction can differ significantly from an ordinary sale.
In particular, losses on sales between related parties are disallowed, and this affects the subsequent sale of the same property to an unrelated third party. Understanding the implications of these disallowed losses and how they can impact future gain or loss calculations is critical to ensuring accurate tax reporting and compliance. This article will guide you through the rules governing such transactions, including how to calculate gain or loss when the property is later sold to a third party, ensuring you are well-prepared for both real-world applications and exam scenarios.
Importance for the TCP CPA Exam
For TCP CPA exam candidates, mastering the rules surrounding related party transactions and the subsequent sale to unrelated parties is crucial. The complexity of these transactions, including disallowed losses, basis adjustments, and gain recognition, requires a deep understanding of tax regulations. The IRS closely scrutinizes related party transactions to ensure tax avoidance schemes are not used to manipulate financial outcomes, which is why exam candidates must be proficient in the calculations and rules governing these sales.
This topic plays a key role in tax planning, as it impacts both individual and corporate tax strategies. From a compliance perspective, accurately determining the gain or loss on these transactions is vital to avoid potential IRS penalties or audits. On the TCP CPA exam, you may be tested on how to properly apply IRC Section 267, calculate the impact of disallowed losses, and ensure accurate reporting of gains or losses on related party sales. This article will equip you with the knowledge needed to confidently address these concepts in both your studies and future practice.
Defining Related Party Transactions
IRC Section 267 Overview
IRC Section 267 governs related party transactions, focusing on the tax treatment of sales or exchanges between individuals or entities that share close relationships. The primary purpose of Section 267 is to prevent taxpayers from manipulating tax results by selling assets between related parties in ways that would artificially create deductible losses or defer income recognition. Under this provision, specific rules disallow the deduction of losses on sales or exchanges between related parties. In addition, Section 267 restricts certain deductions for expenses and interest paid between related parties, to prevent abuse of tax benefits.
At the core of Section 267 is the disallowance of losses on property sales between related parties, meaning that if a loss occurs during the sale of property between related parties, it cannot be deducted for tax purposes. This rule is designed to block the creation of tax benefits from transactions that don’t reflect an arm’s-length relationship, where the parties may have non-tax motivations influencing the transaction.
Examples of Related Parties
Under Section 267, related parties include individuals and entities that are connected by family or business relationships. The IRS defines several categories of related parties, including but not limited to:
- Family Members: Related parties include immediate family members, such as parents, siblings, children, spouses, and grandparents. For tax purposes, these family members are treated as related parties even if they act independently in their financial dealings.
- Corporations and Shareholders: A corporation and a shareholder who owns more than 50% of the corporation’s stock are considered related parties. Additionally, two corporations that are part of a controlled group (e.g., a parent company and its subsidiary) also fall under the related party category.
- Partnerships and Partners: In a partnership, transactions between the partnership and its partners are considered related party transactions if a partner owns more than a specified interest in the partnership.
- Trusts and Beneficiaries: A trust and its beneficiaries, as well as trustees and grantors, can also be considered related parties in specific contexts under Section 267.
These relationships extend beyond mere familial or direct ownership ties and often include entities that are economically or operationally intertwined.
Implications of Related Party Transactions
The scrutiny of related party transactions by tax authorities arises primarily from the potential for tax avoidance. Transactions between related parties may not occur at arm’s length, meaning the parties could agree to terms that do not reflect market conditions or fair value. This opens the door for manipulating tax outcomes, such as creating deductible losses or artificially deferring income recognition.
For example, a taxpayer could sell depreciated property to a related party at a loss, expecting to generate a tax deduction. Section 267 prevents such a deduction from being recognized, ensuring that the IRS doesn’t lose revenue from transactions that would not have occurred in a market-based setting. Additionally, if the property is later sold to an unrelated third party, special rules dictate how gains and losses from these transactions are treated, ensuring proper tax recognition and closing any potential loopholes.
This strict oversight helps maintain fairness and integrity in the tax system, ensuring that related party transactions do not lead to inappropriate tax benefits. As a result, it is critical for both taxpayers and tax professionals to understand the unique tax rules that apply to these transactions, especially when it comes to accurately calculating gains and losses and complying with IRS reporting requirements.
Gain or Loss Calculation Rules for Related Parties
General Rule for Gain or Loss
In most property transactions, the gain or loss on the sale or exchange of property is calculated by determining the difference between the amount realized from the sale and the seller’s adjusted basis in the property.
- Amount Realized: This is the total money and fair market value (FMV) of any property received by the seller in exchange for the property. It also includes any liabilities assumed by the buyer.
- Adjusted Basis: The adjusted basis of the property is the original purchase price (cost basis), adjusted for factors such as depreciation, improvements, or damage to the property.
The formula for calculating gain or loss is:
Gain or Loss = Amount Realized – Adjusted Basis
- If the amount realized exceeds the adjusted basis, the seller has a gain.
- If the adjusted basis exceeds the amount realized, the seller incurs a loss.
This general rule applies to sales or exchanges of property between unrelated parties. However, for related party transactions, specific tax rules modify the treatment of losses and gains under IRC Section 267.
Non-Deductibility of Losses
Under IRC Section 267(a)(1), losses on the sale or exchange of property between related parties are disallowed for tax purposes. This means that even if a loss is incurred in a sale between related parties, the seller cannot deduct that loss on their tax return. The IRS disallows these losses to prevent related parties from using such transactions to create artificial tax benefits, such as generating deductions without a genuine economic impact.
However, while the loss is disallowed, it isn’t completely lost. Instead, the disallowed loss is carried over and affects the buyer’s basis in the property. Specifically, the buyer’s basis in the property is the same as the seller’s adjusted basis at the time of the transaction.
If the buyer subsequently sells the property to an unrelated third party, the previously disallowed loss can potentially be used to reduce any gain recognized on the sale. This ensures that the loss is recognized only when the property leaves the related party structure and is sold at arm’s length to an unrelated buyer.
Special Consideration for Gain
In contrast to losses, gains from sales between related parties are treated differently. Gains are fully recognized and taxable to the seller, even in transactions between related parties. This means that if the amount realized in a related party transaction exceeds the adjusted basis of the property, the seller must report and pay taxes on the gain, just as they would in an arm’s-length transaction.
Notably, a gain is recognized even if the sale is made below market value. This occurs because the amount realized, rather than the fair market value, is used to determine the gain. As long as the amount realized is higher than the seller’s adjusted basis, the seller will recognize a gain and owe taxes on that gain, regardless of the relationship between the parties.
In summary:
- Losses between related parties are disallowed but can affect the buyer’s future basis in the property.
- Gains are recognized and taxable, even in related party transactions and even when the sale occurs at a below-market price.
These rules ensure that tax avoidance strategies are minimized in related party transactions, while still allowing for proper tax recognition of gains and losses when property is ultimately sold to an unrelated party.
Subsequent Sale to an Unrelated Third Party
Scenario Overview
A common scenario involving related party transactions occurs when one related party sells property to another related party, followed by the second party selling the property to an unrelated third party. In this situation, the tax treatment of the initial sale between related parties affects the subsequent sale to the third party.
For instance, imagine a parent selling a property to their child at a loss. Under IRC Section 267, the loss on the initial sale is disallowed, meaning the parent cannot claim a tax deduction for that loss. However, this disallowed loss isn’t forgotten—it gets carried over and impacts the child’s basis in the property. When the child later sells the property to an unrelated third party, the disallowed loss may be used to reduce any gain recognized on the sale to the third party. Understanding how to calculate the gain or loss on this subsequent sale is key to determining the correct tax consequences.
Calculating Gain or Loss on the Third Party Sale
When the property is sold by the related party (in this case, the child) to an unrelated third party, the calculation of the gain or loss depends on the basis the child has in the property, which includes adjustments from the disallowed loss. The calculation follows these general steps:
- Determine the Basis of the Property: The child’s basis in the property is generally the same as the parent’s adjusted basis at the time of the initial sale. Any disallowed loss from the initial related party transaction is carried over into this basis. The child cannot use the purchase price they paid to the parent to determine their basis.
- Apply the Amount Realized from the Sale: When the child sells the property to an unrelated third party, the amount realized from the sale is compared to the adjusted basis (which includes the disallowed loss from the initial sale).
- Calculate the Gain or Loss:
- If the amount realized from the sale exceeds the adjusted basis, the child recognizes a gain.
- If the amount realized is less than the adjusted basis, the child incurs a loss. However, in certain cases, the previously disallowed loss from the initial related party sale may now be recognized and applied against the gain, reducing the tax impact.
Double-Basis Rules
The concept of double-basis rules applies when the property is transferred in a related party transaction at a loss, and the property is later sold to an unrelated third party. This rule is crucial for determining whether the disallowed loss from the initial related party sale can be recognized when calculating gain or loss on the subsequent sale.
- Gain Scenario: If the amount realized in the sale to the third party is greater than the original seller’s basis, any previously disallowed loss remains unrecognized. The gain is calculated using the adjusted basis carried over from the original seller, and no adjustment is made for the disallowed loss.
- Loss Scenario: If the amount realized in the sale to the third party is less than the original seller’s adjusted basis, the double-basis rules allow the disallowed loss to be recognized. The loss from the original related party transaction now reduces the gain on the sale to the unrelated third party, effectively allowing the related party to “recoup” the disallowed loss.
These rules ensure that taxpayers cannot manipulate related party transactions to generate artificial tax deductions, while still allowing a fair outcome when the property is ultimately sold to an unrelated party.
In summary:
- The related party’s basis, which includes any disallowed losses, is key to calculating gain or loss when the property is sold to a third party.
- The double-basis rules determine whether previously disallowed losses can be recognized in the subsequent sale, depending on whether a gain or loss is realized in the final transaction.
Step-by-Step Example Calculation
Illustrative Example
Let’s walk through a hypothetical example to better understand how gain or loss is calculated in related party transactions and subsequent sales to unrelated third parties.
Initial Sale Between Related Parties
Suppose a parent sells a property to their child. The parent originally purchased the property for $200,000, and over time, the property’s adjusted basis (after depreciation) is now $150,000. The fair market value of the property at the time of sale is $130,000, but the parent sells it to the child for $130,000, resulting in a loss of $20,000 ($150,000 adjusted basis minus $130,000 sale price).
- Adjusted Basis of the Parent: $150,000
- Amount Realized by Parent: $130,000
- Loss: $150,000 – $130,000 = $20,000
However, since this is a related party transaction, the $20,000 loss is disallowed under IRC Section 267(a)(1), and the parent cannot claim the loss on their tax return. The child’s basis in the property becomes the parent’s adjusted basis at the time of sale, which is $150,000. The disallowed loss is carried over to the child and will affect the gain or loss on the future sale.
- Child’s Basis in the Property: $150,000 (original adjusted basis of the parent, not the purchase price of $130,000)
- Disallowed Loss: $20,000 (which could potentially be recognized later)
Subsequent Sale to Unrelated Third Party
Now, suppose the child later sells the property to an unrelated third party. The calculation of gain or loss depends on the sale price and how it compares to the child’s basis, which includes the disallowed loss.
Scenario 1: Sale Price Higher than the Child’s Basis
- Let’s assume the child sells the property to a third party for $170,000.
- Child’s Adjusted Basis: $150,000
- Amount Realized: $170,000
- Gain: $170,000 – $150,000 = $20,000
In this case, the disallowed loss from the original sale does not affect the calculation. The child recognizes a gain of $20,000 on the sale, which is fully taxable.
Scenario 2: Sale Price Lower than the Child’s Basis but Higher than the Original Sale Price
- Now, assume the child sells the property for $140,000.
- Child’s Adjusted Basis: $150,000
- Amount Realized: $140,000
- Loss: $140,000 – $150,000 = $10,000
Although this is a loss for the child, they can now recognize part of the original disallowed loss. The child sold the property for $140,000, which is higher than the original sale price of $130,000 but lower than their adjusted basis. The disallowed loss of $20,000 can offset this sale. The child’s recognized loss is now $10,000.
Scenario 3: Sale Price Lower than Both the Child’s Basis and the Original Sale Price
- Finally, suppose the child sells the property for $120,000.
- Child’s Adjusted Basis: $150,000
- Amount Realized: $120,000
- Loss: $120,000 – $150,000 = $30,000
Here, the child recognizes the entire disallowed loss from the original transaction. The loss from the sale to the unrelated third party ($30,000) includes both the $20,000 disallowed loss from the initial sale and an additional $10,000 loss from this new transaction. Therefore, the child’s recognized loss is $30,000.
Impact of Different Sale Prices
As shown in the scenarios above, variations in the sale price to the unrelated third party impact the calculation of the recognized gain or loss:
- Sale Price Above Basis: If the sale price is higher than the child’s basis, the disallowed loss is not recognized, and the child recognizes a gain.
- Sale Price Below Basis but Higher than Original Sale Price: The child can recognize part of the disallowed loss, reducing the amount of gain or increasing the recognized loss.
- Sale Price Below Both Basis and Original Sale Price: The child can fully recognize the disallowed loss from the original sale and may incur additional losses from the sale to the third party.
This example illustrates how the disallowed loss from a related party sale can impact future transactions and how varying sale prices affect the recognized gain or loss. Understanding this framework is critical for accurate tax reporting and compliance.
Tax Reporting and Compliance
Reporting the Transaction
When engaging in related party transactions, especially when there is a subsequent sale to an unrelated third party, it is crucial to report the transaction properly to the IRS. Related party sales, gains, and disallowed losses have specific tax reporting requirements. Here are the key forms and schedules involved:
- Form 8949 (Sales and Other Dispositions of Capital Assets): This form is used to report the sale of capital assets, including property. If there is a disallowed loss from a related party transaction, this should be noted on Form 8949. The form allows you to report any adjustments to gain or loss that arise due to special tax rules, such as disallowed losses under IRC Section 267.
- When completing Form 8949, taxpayers must provide details about the property sold, including the date of acquisition, the sale date, the amount realized, and the adjusted basis in the property. In the case of disallowed losses from a related party sale, adjustments must be made, and this adjustment must be noted in column (g) of Form 8949 using a special code to explain the nature of the disallowed loss.
- Schedule D (Capital Gains and Losses): This schedule is used in conjunction with Form 8949 to calculate the total capital gain or loss for the tax year. Gains or losses from related party transactions, including any adjustments made for disallowed losses, flow from Form 8949 into Schedule D, where they are aggregated with other capital gains or losses.
- Form 4797 (Sales of Business Property): If the property sold between related parties was used for business purposes, the sale may need to be reported on Form 4797 instead of Form 8949. This form is used to report sales of business property and includes sections for gains or losses from related party transactions. The same rules for disallowed losses apply, and adjustments for related party sales should be reported here.
- Form 1040 (U.S. Individual Income Tax Return): The results from Schedule D or Form 4797 ultimately flow into the taxpayer’s Form 1040, where gains or losses are factored into the overall income calculation. Properly reporting related party transactions ensures that taxable gains are included, and disallowed losses are correctly adjusted.
Potential Penalties for Non-Compliance
Failure to properly report related party transactions or account for disallowed losses can lead to significant tax penalties. Some of the common penalties and issues that can arise include:
- Accuracy-Related Penalties: If a taxpayer underreports income or overstates losses due to the failure to recognize disallowed losses or misreporting gains from related party transactions, they could face an accuracy-related penalty. This penalty is typically 20% of the underpayment of tax due to negligence or disregard of IRS rules.
- Underpayment of Estimated Taxes: If the gains from related party transactions are not correctly reported and lead to a substantial underpayment of estimated taxes, the taxpayer may be liable for an underpayment penalty. This applies especially in cases where the taxpayer fails to account for capital gains that should have been included in quarterly estimated tax payments.
- Negligence Penalties: If the IRS determines that the taxpayer was negligent in reporting related party transactions—either by failing to report a disallowed loss or improperly reporting the gain on a sale—additional negligence penalties may apply. This penalty can be up to 20% of the amount underreported.
- Failure to File or Pay Penalties: If taxpayers fail to report or pay the appropriate tax on gains from related party transactions, they may incur failure-to-file penalties (up to 5% per month of the unpaid tax, up to 25%) or failure-to-pay penalties (up to 0.5% per month of unpaid tax).
- IRS Audit Triggers: Related party transactions are often subject to scrutiny by the IRS because of the potential for tax avoidance. Misreporting these transactions, failing to recognize gains, or not accounting for disallowed losses can increase the likelihood of an audit. Inaccuracies or omissions on the related party transaction could lead to further tax investigations and penalties.
Correct and timely reporting of related party transactions and the associated disallowed losses or gains is essential to avoid IRS penalties and ensure compliance. Careful attention to the rules under IRC Section 267 and adherence to the correct tax forms can help mitigate risks and maintain tax compliance.
Conclusion
Key Takeaways
Understanding the tax implications of related party transactions, especially when there is a subsequent sale to an unrelated third party, is crucial for tax planning and compliance. The key points to remember include:
- Basis Adjustments: In related party transactions, the basis of the property transferred is critical. When property is sold between related parties, any disallowed loss is carried over and affects the buyer’s basis in the property. This adjusted basis plays a significant role in determining the gain or loss when the property is later sold to an unrelated third party.
- Disallowed Losses: Under IRC Section 267, losses on sales between related parties are disallowed to prevent tax avoidance. However, these disallowed losses aren’t permanently lost—they affect the buyer’s basis and may be recognized in future transactions, particularly when the property is sold to an unrelated third party.
- Recognition of Gains: Gains in related party transactions are fully recognized and taxable, even if the sale occurs at below-market value. These gains must be reported properly to avoid IRS penalties.
- Double-Basis Rules: When the property is sold to an unrelated third party, the disallowed loss from the initial related party sale can often be recognized, depending on the sale price. Understanding how the double-basis rules apply is essential for accurate tax calculations.
By keeping these key concepts in mind, you can navigate the complexities of related party transactions and ensure compliance with the IRS rules.
Final Tips for TCP CPA Exam
For the TCP CPA exam, understanding related party transactions is critical. Here are some final tips to help you prepare:
- Recognize Related Party Transactions: Be sure to identify when a transaction falls under IRC Section 267. Familiarize yourself with the types of relationships that qualify as related parties, including family members, business entities, and partnerships.
- Focus on Basis Adjustments: Remember that the basis of the property in related party sales is key to calculating the future gain or loss. Be prepared to adjust the basis when there are disallowed losses and know how this impacts the subsequent sale.
- Understand Disallowed Losses: Know when losses are disallowed in related party transactions and how those disallowed losses carry over to affect future sales. Be able to explain when the disallowed loss can be recognized in a sale to a third party.
- Be Familiar with IRS Forms: Practice reporting related party transactions on the correct IRS forms, such as Form 8949 and Schedule D. Accurate tax reporting is an important part of the compliance process.
By focusing on these areas, you’ll be well-equipped to handle questions related to related party transactions, basis adjustments, and the calculation of gains or losses in both the exam and real-world practice.