YOUR INVESTMENT holdings might include an asset that’s dropped in value since you bought it. Still, you have great hopes for the investment: While you’d like to sell and get the tax loss, you really hate to part with your old friend. Should you instead sell it to your spouse or your child?
You can usually claim losses on investments when you sell them. But IRS code section 267 generally disallows deductions for losses on sales to certain family members and other related parties. Under the loss disallowance rules, related parties include close relatives, such as a spouse, child, grandchild, parent, brother or sister, or a company in which you own more than 50% of the stock.
Good faith sales. The law authorizes the IRS to invoke the related-party rules even if you make the sale in “good faith”—that is, without intending to avoid taxes—or involuntarily, as when a family member forecloses on the mortgage he or she holds on your property. Those rules can also snag an indirect transaction, such as when you sell stock through a public stock exchange and a related party purchases stock in the same company.
An example: You buy 100 shares of DEF Company for $10,000 and later sell them to your sister for $8,000. You can’t deduct your $2,000 loss. Why do these restrictions exist? The goal is to stop tax avoidance through transactions that merely shuffle property back and forth within the same family.
Salvaging disallowed losses. In the above example, your disallowed loss becomes available to your sister in the event she realizes a profit on the sale of her DEF shares. Her profit escapes taxes up to the amount of your disallowed loss.
Her basis for the DEF shares is the $8,000 that she paid you. If she eventually sells them for $9,000, her gain of $1,000 sidesteps taxes because it’s offset by $1,000 of your disallowed loss. If the sales price is $11,000, making her gain $3,000, then she’s liable for taxes on only $1,000 of the gain—the $3,000 gain minus your $2,000 disallowed loss.
Sales to “nonrelated” relatives. The related party rules apply only to losses on sales of property to related parties such as your sister or son. Those restrictions don’t bar a deduction by you for a loss on the sale of the DEF shares to an in-law, such as a brother-in-law or daughter-in-law.
That brings me to an often-overlooked strategy. Let’s say your DEF shares have declined drastically and you wish to realize some of your paper loss without being out of the stock for an extended period. Under yet another set of restrictions, known as the wash-sale rule, your loss on a sale of the DEF shares is currently deductible only if the repurchase takes place more than 30 days before or after the sale.
What to do? To maneuver around these various rules and get your tax loss, while keeping the DEF shares in the family, just make a bona fide sale to an in-law. Instead of selling the stock on the open market, get a current quote and sell the stock at the market price to any in-law with whom you enjoy a good relationship. This will keep the benefit of a future upturn within the family—and you’ll have your deductible loss.
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator). His previous articles include Now or Later, Good Old Days, Two’s a Crowd and Stepping Up. Information about his books is available at JulianBlockTaxExpert.com. Follow Julian on Twitter @BlockJulian.