Knowledge About Tax Law Changes Is Your Best Weapon
By Christine Hall
Ignorance is no excuse for breaking the law and that includes taxes. New laws are constantly created and then “clarified” through the court system which typically causes a new law to be enacted. The summary of tax law changes in 2015 was more than 300 pages, and that was just the summary!
Even though there is no way to know all of the current laws, the Internal Revenue Service agrees that ignorance is no excuse.
Knowledge is the best weapon. Reading and being aware of laws, even if you can’t recite them verbatim, is a huge advantage. If and when the subject matter becomes a concern, if you at least have something stored in the back of your brain that it could be an issue, you are ahead of most others.
In this article I would like to make you aware of a few issues concerning related-party transactions. There are tax consequences when dealing with related parties in business. If you are an individual taxpayer only, don’t stop reading; these transactions may affect you as well.
A good example I see quite often is a taxpayer allowing a relative to live rent-free in a rental home for which they claim expenses. The old saying, “Nothing is ever free,” is quite true!
Generally, a related party is defined as the seller’s immediate family: brother or sister (whole or half-blood), spouses, ancestors and lineal descendants. A related party is also a controlled group, as in entities that have the same owner(s). As a caution, different types of transactions define related-party members differently. If you believe you are or may be involved in a related-party transaction, do your homework before the transaction takes place.
The law is that you cannot deduct a loss on the sale or trade of a property between related parties. The disallowance rules prevent taxpayers from manipulating recognition of losses for tax purposes when an economic loss has not been realized. The rules apply to any sale or exchange, even if it is a bona fide sale and the terms are determined on a fair market basis.
Gains are recognized and are taxed accordingly. If multiple properties are sold, the gains and losses must be computed separately so that gains can be recognized and losses can be forfeited. An aggregate of gains and losses cannot be computed and reported as such on the sale of multiple properties.
In the situation of allowing a relative to live in a rental home rent-free, it is the unrecognized rental income that becomes the problem. In this case, the transaction is treated as an arms-length transaction, meaning the IRS looks at it as if the rent were actually received and expects the taxpayer to pay tax on it accordingly.
The IRS views the transaction as follows: The taxpayer gifts the rent to the relative; the relative accepts the gift and then pays the rent back to the taxpayer, who in turn reports it as rental income. Rental income is taxable, but gifts are nondeductible.
Doing business with a related party is certainly acceptable, assuming it is handled appropriately on your tax return. There may be little benefit for doing business with a related party, and a mishandled transaction can actually hurt a taxpayer. Be sure you check the implication of the transaction with a qualified tax preparer before you carry it out, because an anticipated loss may not be beneficial.