Related Party Transaction

10.1 Related Party Sales

General Rule: Special rules to prevent tax avoidance between related parties.

Who is Related? (Sec. 267)

• Family: Ancestors, lineal descendants, spouses, and siblings. (Note: Nieces/nephews are NOT included).

• An individual and a corporation if the individual owns > 50% of the stock.

• A partnership and a partner owning > 50% of the capital or profits interest.

• Trusts and their beneficiaries.

• Constructive ownership rules apply (you are deemed to own stock owned by your family).

Key Rules & Consequences:

1. Loss Disallowance: No loss is recognized on the sale of property to a related party.

   • The related buyer's basis is their cost (what they paid).

   • Subsequent Sale by Buyer: If the buyer later sells the property to an unrelated party:

     • Gain: The buyer's recognized gain is reduced by the seller's previously disallowed loss.

     • Loss: The buyer's recognized loss is not adjusted by the seller's disallowed loss.

   • Exception for Tax-Indifferent Parties: If the original seller was tax-indifferent (e.g., foreign person, tax-exempt org), the disallowed loss is permanently lost and does not reduce the buyer's future gain.

2. Gain Recharacterization: If you sell an asset at a gain to a related person, and that asset is depreciable in the related person's hands, the gain is ordinary income (not capital gain).

Important Exceptions:

• Employer-Employee: An employee is not a related party to the employer. A bargain sale is treated as compensation.

• Interspousal Transfers: No gain or loss is recognized on transfers between spouses (or incident to divorce). The receiving spouse takes a carryover basis.

10.2 Business Property (Depreciation Recapture)

Purpose: To prevent a "double benefit" of taking ordinary deductions for depreciation and then getting capital gains rates on the sale.

Section 1245 Property ("Personal Property")

• What it is: Depreciable personal property (machinery, equipment, vehicles, patents, livestock).

• Recapture Rule: All depreciation taken is recaptured as ordinary income to the extent of the gain realized.

  • Gain = Selling Price – Adjusted Basis.

  • Ordinary Income = Lesser of (Total Depreciation Taken) or (Gain Realized).

  • Any remaining gain after full depreciation recapture is Section 1231 gain.

Section 1250 Property ("Real Property")

• What it is: Depreciable real property (buildings, structural components).

• Recapture Rule: Generally, only the excess of accelerated depreciation over straight-line is recaptured as ordinary income. However, since SL is required for most real property post-1986, Sec. 1250 recapture is rare.

• Unrecaptured Section 1250 Gain (for Individuals):

  • The portion of the gain equal to the straight-line depreciation taken is taxed at a maximum 25% rate.

  • Any gain beyond that is Section 1231 gain (taxed at 0/15/20%).

Section 1231 Property ("The Best of Both Worlds")

• What it is: Business property (real or depreciable) held for more than 1 year. Includes land and involuntary conversions.

• The Netting Process:

  1. Net all Sec. 1231 gains and losses for the year.

  2. If Net Gain: The net gain is treated as a Long-Term Capital Gain.

  3. If Net Loss: The net loss is treated as an Ordinary Loss (which is better than a capital loss).

• The "Look-Back" Recapture Rule (Sec. 1231(c)): If you have a net Sec. 1231 gain this year, you must recapture it as ordinary income to the extent of your nonrecaptured net Sec. 1231 losses from the prior 5 years.

Order of Application:

1. Apply Sec. 1245 recapture (all depreciation is ordinary income).

2. Apply Sec. 1250 recapture (rare) and Unrecaptured Sec. 1250 Gain (25% rate).

3. Apply Sec. 1231 Look-Back recapture (to the extent of prior 5-year losses).

4. The remaining gain is Net Sec. 1231 Gain (LTCG).

10.3 Installment Sales

General Rule: A sale where at least one payment is received in a tax year after the year of sale. Gain is recognized proportionally as payments are received.

Formula:

• Gross Profit = Selling Price – Adjusted Basis – Selling Expenses

• Contract Price = Selling Price – Mortgages Assumed by Buyer (with special rules if mortgage > basis)

• Gross Profit Percentage (GPP) = Gross Profit / Contract Price

• Gain Recognized Each Year = GPP × Payments Received in That Year

Key Inclusions/Exclusions:

• Cannot Use for: Dealer inventory, sales of publicly traded stocks/securities.

• Can Use for: Land, real property, business assets, and certain residential lots/farms.

Special Rules:

• Depreciation Recapture: The full amount of Sec. 1245/1250 recapture gain is recognized in the year of sale, regardless of payments received. Only the remaining gain (Sec. 1231) is deferred under the installment method.

• Related Party Anti-Avoidance Rule: If a related buyer resells the property within 2 years, the original seller must recognize gain in the year of the second disposition.

• Disposition of Installment Obligation: Selling the note is a taxable event.

  • Gain/Loss = Amount Realized – Basis in Obligation

  • Basis in Obligation = Face Value × (100% – GPP)

Repossession:

• If the seller repossesses the property, they recognize gain or loss based on the FMV of the repossessed property and the basis of the unpaid installment obligation.

By mastering these key points, you will be well-prepared to tackle exam questions on these complex but highly testable topics.