IRS Rules on Real Property Sales to Relatives

The IRS gets very suspicious about business transactions between relatives, property sales included.

The IRS gets very suspicious about business transactions between relatives. Working together, relatives could engage in sham sales of business or investment property in order to produce fake tax deductible losses.

How U.S. Tax Code Prevents Fraud by Family Co-Conspirators

The U.S. tax code contains a simple rule to prevent family from creating fake tax deductions: You cannot deduct a loss on the sale or trade of property if the transaction is directly or indirectly between you and a relative.

Example: Marc owns a rental property with a $100,000 adjusted basis. He sells it to his daughter Marcia for $75,000. He may not deduct any part of his $25,000 loss.

Definition of a 'Relative' for Tax Purposes

For these purposes, "relatives" includes your brothers and sisters, half-brothers and half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, and so forth). Thus, for example, cousins and in-laws are not relatives for tax purposes.

Can Losses on Sale to Relatives Ever Offer Tax Benefits?

What happens to such losses, in tax terms? They go to the relative who purchased the property. But the tax law restricts how they may be deducted.

If the relative who purchased the property later resells it to an unrelated third party at a gain, he or she may deduct the previously disallowed loss from the gain. However, this deduction is limited to the amount of the gain from the sale to the third party. Any loss above this amount effectively disappears for tax purposes.

Example: Marcia resells the rental she purchased for $75,000 from her father to an unrelated third party for $90,000, realizing a $15,000 gain ($90,000 sales price - $75,000 basis = $15,000 gain). Marcia may deduct from her gain $15,000 of the $25,000 loss that was disallowed when she purchased the property from her father. The remaining $10,000 of this loss disappears.

However, if you sell property you acquired from a relative at a loss, you cannot deduct the previously disallowed loss at all. The entire loss disappears.

Example: Assume that Marcia sold her rental property for $60,000, resulting in a $15,000 loss (remember, she purchased the property for $75,000). She may deduct this loss. But she cannot deduct any part of the previously disallowed $25,000 loss. It is lost forever.

If you sell or trade to a relative a number pieces of property in a lump sum, you must figure the gain or loss separately for each piece of property. The gain on each item might be taxable. However, you cannot deduct the loss on any item. Also, you cannot reduce gains from the sales of any of single piece of property by losses on the sales of any other piece of property.

The moral: Don't sell business or investment property at a loss to relatives.

For more information on the subject, see IRS Publication 544, Sales and Other Dispositions of Assets.

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