Related Party Sale May Have Unexpected Results

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Sale, exchange or distribution of appreciated property between related parties can create certain adverse tax consequences for sellers including recharacterizing capital gains as ordinary income, denying installment sales reporting, disallowing realized losses and restricting the use of like-kind exchanges.

Gain on the sale of depreciable real property held for more than one year can be subject to three (3) different tax rates.  Depreciation recapture is taxed as ordinary income at a max rate of 35%.  Unrecaptured gain on depreciable real property is taxed at a max rate of 25%.   And long-term capital gain is taxed at the capital gain rate (currently at a max rate of 15%).

In addition, under Internal Revenue Code section 1239, gain that would otherwise be treated as capital gain is converted to ordinary income if the property was depreciable and was sold, exchanged or distributed between related parties. This rule applies to property that can be depreciated by the buyer, whether or not the seller could depreciate the property and whether or not the buyer chooses to depreciate the property.  The special rule of section 1239 does not apply to property such as raw land which is not depreciable.

When applying the depreciation recapture rules and the special rule of section 1239 to a related party sale, the seller first allocates the gain on sale of the property between the depreciable property and the non-depreciable property.  The seller then applies the depreciation recapture rules to the portion of the gain attributable to the depreciable property.  The remainder of the gain on the depreciable property if any is then treated as ordinary income under section 1239.

For purposes of section 1239, “related parties” include a taxpayer and all controlled entities.  In determining who are related parties, the constructive stock ownership rules apply.  Similar but different rules apply where the property is held by a partnership.  More about that in a future blog.  Please call or email me at 937-223-1130 or Jsenney@pselaw.com if you have any questions or comments.

AND ONE MORE THING.  The federal estate tax exemption in 2012 is $5,120,000.  The federal estate tax exemption is scheduled to return to $1,000,000 in 2013.  With this in mind, some people are gifting real estate and other appreciated assets to their children and grandchildren this year.   And to get even more bang for the buck, people are contributing these appreciated assets to an LLC or other closely-held company, and then gifting ownership interests in the LLC rather than gifting the appreciated asset itself.  The reason?  Valuation discounts of 30 to 40% can be taken when gifting a minority interest in an LLC rather than gifting the appreciated asset itself.   If you are interested in doing some end of year gifting, please give me a call.   Jsenney@pselaw.com or 937-223-1130