When Transacting with Family Members, Keep an ‘Arms Length’

We’ve all heard it – never do business with friends or relatives … but how many of us still do  (especially when real or personal property is involved)? As a rule, the IRS takes a very close look at financial transactions between family members, which is why it’s wise to k

Retired Pair on Porch of Beach House
Tax issues frequently arise when you do business with family members. For example, if you were to agree to sell your vacation home to your son, and he pays your original price, the warning bells are sure to sound. That’s because the IRS is bound to have more than a few questions … was your selling price the fair market value? Did your son get an appraisal of the property? Did comparable properties sell at similar prices? The list goes on … contact a tax pro to make sure you are preempting these questions and avoiding the headaches.

now what you are dealing with in advance.

Why Does The IRS Scrutinize Transactions Between Family Members?

If you’re contemplating selling property to  ̶  or buying from  ̶   a family member, you need to evaluate the potential negative tax consequences before entering into a transaction. As a worst-case scenario, the IRS could set aside the transaction as if it never took place, which would mean whatever gain or loss you have, would evaporate.

The reason the IRS scrutinizes these transactions is because they are rarely “arms-length” transactions, which means that pricing is established as if the buyer and seller are independent parties. With an “arm’s length” transaction, the seller must want to sell his or her property at a fair market price  ̶  and the buyer must also offer a fair price. These transaction should not be for tax avoidance. The IRS will determine if the sale was fair, a gift or bogus and impose penalties.

Read Also: Inside The Family Business: Boundaries And Best Practices

Tax issues frequently arise with these transactions. For example, if you agree to sell your vacation home to your son, and he pays your original price, warning bells may sound. Was your selling price the fair market value? Did your son get an appraisal of the property? And, did comparable properties sell at similar prices?

Trying to claim a loss on the sale is usually disallowed as there are specific tax rules regarding a loss from the sale or exchange of property when it is between family members regardless of whether you can prove the price is fair. The IRS’s definition of family is very broad in this instance and includes brothers and sisters (even half-blood), spouses and direct ancestors and lineal descendants (including adopted children). Nieces and nephews, aunts, uncles and in-laws are excluded as are step-family members.

The IRS is also likely to question you if you try to claim a gain on the sale if your return is audited. The IRS can claim that you didn’t recognize enough gain, hoping to tax the rest as a taxable gift. In selling property to a family member, you should keep a record of comparable prices in case the IRS audits your return.

Divorce can also spawn tax consequences. Courts often direct one spouse to transfer property to the other. Generally, no gain or loss is recognized when property is transferred incident to the divorce. If the transaction is not “incident to the divorce” and a spouse claims large losses, the IRS will carefully examine if the transaction was genuine.

Also, gains or losses are not recognized if a transfer takes place between married spouses even if they don’t file a joint return (or if their relationship is amicable or not).

Anticipate The Challenges

If your transaction is scrutinized by the IRS, be sure to get professional backup. Better yet, be proactive by anticipating potential challenges and taking some simple, common-sense steps:

  • Be prepared. Document every step of your related party transaction. All agreements should be in written format, and corroborating evidence should be retained.
  • Invest in an independent appraisal. Have an expert value the property. Having an independent third party verify the reasonableness of the transaction price is what the IRS likes to see.
  • Weigh alternatives. Maybe gifting the property to a family member is a better option. The positive tax consequences of gifting are often overlooked.

There is nothing wrong with engaging in financial transactions with family as long as all parties are aware of the possibility of added scrutiny. Be smart and properly prepare for such an event. If you are contemplating such a transaction, email Rea & Associates to speak with a tax pro. You’ll be glad you did.

By Judy Mondry, CPA, CVA (Cleveland office)

Looking for more insight to help you manage your family business? Check out these articles:

Assessing Where You, Your Family And Your Business

Succession Planning Is Especially Important For Family-Owned Businesses