 Hello and welcome to this session in which we will discuss related party transaction and another related topic to it is the imputed interest between the related parties. Now related party transactions falls under the umbrella of disallowed losses. So certain losses that we cannot use. We have certain losses that can be deferred which we'll talk about later and we already discussed certain losses that could be deferred for example in a qualified 1031 exchange. However when it comes to related party transaction we have to understand the rules because simply put the losses are not allowed. Now we have to also keep in mind that related party transaction is covered in the financial accounting and reporting. So you need to know what related party is for financial accounting and reporting for auditing purposes we cover related party transaction and now you are seeing the same topic in tax. Simply put what I'm trying to say is this related party transactions are important whether you are reporting for financial accounting auditing or tax purposes. Now what is considered related parties for tax purposes. For tax purposes related parties can be any of the following members of your family including brothers sisters have brothers have sisters spouse ancestors people above you and lineal descendant people below you above you means your parents grandparents children grandchildren etc. Also if you own 50% or more in a partnership or a corporation this becomes a related party transactions related parties whether that ownership is direct or indirect or if you control a tax exempt charitable tax exempt charity or educational organization by you or any family member those are related party to you therefore they could create a related party loss. Before we proceed any further I have a public announcement about my company farhatlectures.com. 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Now related party transaction under section 267 taxpayers are not allowed to deduct losses on related party transaction however if you generate gains by all means IRS loves it you will pay taxes on that those are taxable the losses are not allowed the main reason for the IRS to disallow the losses is that that the seller may retain some sort of a control over over the sold property through his related party or her related party so simply put when you are transacting with the related party the assumption is you control the other party so you might be able to set the price and create the loss or you might sell it and stay in control of the asset so this is why related parties they are looked at differently okay although taxpayers are not allowed to deduct the losses when the related buyer subsequently sell the property he or she recognized gain only to the extent that he or she realizes the gain exceeds the previously this allowed loss so once the other party the buyer sells it to a party other than the related party it means an outside party then the gain is recognized to the extent that the realized loss exceed the previously this allowed loss if any but will work an example in other words this allowed losses might be used to reduce the gain on a future disposition of the property to an unrelated party so after you sell it we might be able to use this loss we will see in an example how it works if the if the property was subsequently sold to unrelated party at a loss so it was initially at a loss then you sold it again in a loss the deduction of the loss is limited to the loss realized by the new seller so you cannot use the loss that was this allowed originally between the related party your loss is the new loss in other words the taxpayer cannot use the previously this allowed loss to increase his or her recognized loss any remaining loss expires expired unused basically it's done the rules above apply to property used for business or investment remember any loss from personal use property is treated as a personal loss and not this allowed altogether now the best way to illustrate this is to look at an example Adam sold property with an adjusted basis of 7,000 to a sister Marlin for 4,000 so the selling price was for the adjusted basis is 7 Adam realized a loss of 3,000 that's the loss however the loss is this allowed because it's between related parties after two month Maryland sold the property to unrelated party 49 now how much did Maryland paid for the party Maryland paid for she sold it for 10 so 10 minus 4 she had a gain from this of 5,000 now what she can do she can use this unrecognized loss here and bring her gains down to 2,000 well she could bring the gain down to 0 if need be but no more than 0 okay so so notice what happened the $3,000 loss by Adam this was this allowed she was able to use it later on now let's talk about the holding period the holding period for a property acquired family from a related party always begin on the date the property is acquired so when you bought it that new transaction established the holding period the start date of the holding period regardless of the original owner holding period so the new holding period start with the new transaction this is important for determining the nature of the gain or the loss to be recognized on the subsequent disposition example Susan sold the property to her brother Alex for 8,700 8,700 Susan basis was 10,000 well as a result Susan's going to have a loss of 1,300 Alex eventually sold the property to unrelated party for 12 for Alex sold it for 12 Alex paid 8,700 therefore the difference between 12,000 and 8,700 is the gain 12,000 minus 8,700 is the gain for Alex which is 3,300 this is a gain okay now let's take a look at it determine the amount of the gain or the loss for Susan for Susan the loss is 1,300 however this loss is this allowed now on the other hand the sale transaction performed by Alex is not related party again initially it was 3,300 however Alex can use as the losses from Susan which is 1,300 and as a result his gain will go down to 2,000 Alex recognizes gain is 2,000 how could Susan have avoided the disallowed loss on the sale of the property how would you disallowed the loss sell it on outside party okay assuming this is not a personal use property which is that's what we're assuming sell it to unrelated party and Susan will be able to recognize the loss assume now that Alex sold the property to unrelated party for 7,000 what is the amount of loss that Alex Alex might deduct from the sale of this transaction now assuming Alex rather than 12,000 sold it for 7 he would incur a loss and the loss will be for 1,700 sold it for 7 purchased it from Susan for 8,700 it's 1,700 again assuming this is not a personal use property in other words we cannot tag on we cannot add Susan's losses because also Susan incurred the loss so we cannot add Susan's losses to the 1,700 that Alex is going to recognize assume that Alex sold the property to unrelated party now for 9,000 determine the amount of gain or loss that Alex recognize again let's take a look at it 9,000 is the selling price the adjusted basis for Alex is 8,700 the gain is 300 that's far out the game I should not put the parentheses the gain is 300 now remember Susan has disallowed losses that can be used but the disallowed losses that Alex can use is limited to the 300 so this the disallowed losses can only wipe out the 300 and cannot create additional losses for Alex I'm not sure what was the original losses what was the original losses for Susan 1,300 so simply put 1,000 of losses will go unexpired basically gone Susan that they cannot use it Alex cannot use it it's basically expired now another related party another related topic related party another related topic to related party transaction is tax avoidance avoidance and imputed interest so a little bit of a background about tax avoidance and imputed interest why does it exist think about an individual let's assume an individual has half a million dollar in cash sitting in the bank if this individual let's assume I have this money and if I have this money and I invest this money let's assume I bought stocks and bonds and every year I make just for the sake of illustration I don't know 10% 50,000 dollar in income from this 50,000 investment income now my tax and my tax bracket is 30% so if I make 50,000 in income I have to pay 30% then my tax bill will be 15,000 that's my tax bill per year well here's what people used to do in the past they will take this half a million give it to their kids so for example I'll transfer this money to my son let's assume I'll transfer it to Adam and Adam will invest this money and Adam's tax rate is 20% just we're making numbers up in other words Adam's tax rate is lower than mine it doesn't matter 20 10 15 lower than 30 now Adam will pay well we'll make 50,000 first we'll make 50,000 profit Adam will pay 20% 20% is $10,000 so notice what happened is there's a tax savings of 5,000 and what would happen is I will have a loan against Adam I would say Adam is I am lending you this money basically I have a note against him where I can get my money back so notice what happened here lowering the tax bill so the government starting I believe in the 80s 1984 1985 I don't remember the year they said that's no longer acceptable when you lend money to another related party if it's below interest rate or no interest rate interest would always be computed so that's that's why it's called tax avoidance you cannot avoid taxes and you have to compute what's called imputed interest okay so taxpayers may try to avoid paying taxes to the IRS through transaction with related party to prevent such attempts the IRS imputes interest on the property sales transaction anytime credit are extended to an interest rate below the prevailing interest market rate so we just talked about the loans between the father and the son or between family member also you could have a transaction selling a property and not accounting for the interest component well you have to always involve an interest component as a result individual taxpayer are required to report any foregone interest on a below market loan as an interest income so if you charge someone below market or no interest same concept there is an interest if you sold someone on credit if you sold someone on installment if they're gonna pay you that money later that's a form of a loan and all loans would require you to compute interest part of it okay now below market loans include gift loans compensation related loans loans between corporation and shareholders tax avoidance loan loan to qualified continuing care facilities or any other below market loans gift loans basically somebody given you a gift as a loan basically here's $5,000 you can use it it's a loan it's a gift from me or compensated related loan where the company loan new money to the employee or loans between corporation and shareholders the corporation would lend you money or vice versa you lend the corporation money okay now there are few limitation at exception we need to be aware of it's worth noting that the imputed interest rules do not apply to any day on which the aggregate outstanding amount of gift compensate compensation related loans loans between corporation and shareholder equal or less than 10,000 okay assuming they don't buy income producing property if it's between individual assuming even between individual or the other party assuming they don't buy income producing property simply put if the loan is less than 10,000 and assuming the other party don't buy income producing property then forget it there is no interest we don't have to worry about this that's the first exception in addition if the outstanding amount of a gift loan is equal to or less than 100,000 if the loan now more than 10,000 but less than 100,000 the foregone interest to be included in the lender's income and deducted by the borrower may not exceed the borrower's net income net investment income for that tax here so if the amount is more than 10,000 less than 100,000 well the amount of interest cannot exceed the borrower's net investment income so if the borrower's net investor income is 5,000 that imputed interest cannot exceed that it will be the lower moreover if the net investment income reported by the borrower is less than 1,000 and if the borrower net investment income is less than 1,000 forget it then we will not have any interest computed now all these rules all these exceptions apply assuming that the loan the gift loan is made is not made that's an important word I missed is not made for the purpose of tax avoidance okay if the loan is made for the purpose of tax avoidance well actually I wrote it correct if the loan is made for the purpose of tax avoidance those limitation don't apply so simply put if you're making a loan to avoid paying taxes just you know that's not allowed okay so those rules don't apply the best way to illustrate this is basically to look at few examples now how do we compute the foregone interest the foregone interest is computed as the difference between the amount of interest accrued at the applicable federal rate AFR or simply put the federal rate assuming the interest was payable annually on December 31st and the amount of interest actually payable on the loan for the same period let's take a look at a simple example Maggie loaned her mother Emily $100,000 payable in five years at an annual rate at 0.5 determine Maggie's imputed interest income assuming the federal rate by the IRS for long-term loan is 2.5 Maggie's charging her mother 0.5 but she should charge her 2.5 well the difference is imputed interest so 100,000 times the difference between 2.5 and 5 which is 2% Maggie would have to include in her income an additional $2,000 let's take a look at this comprehensive example to illustrate the limitation assuming for this example the federal rate is 10% and it's computed semi-annually we have five situations starting with Adam Adam is the borrower Adam borrowed $8,500 Adam's net investment income is zero he doesn't have net investment income and the purpose for the loan is education well guess what it's less than 10,000 we don't have to worry about anything no imputed interest is computed and also Adam is not buying income producing property Maggie borrowed 9,300 the borrower net investment income is 500 Maggie's net investment income is 500 she purchased a bond income producing property well the amount is less than 10,000 but it's to purchase an income producing property but but since her net investment income is less than a thousand and the loan is less than a hundred thousand no imputed interest so the $10,000 limit does not apply because she's she's buying a bond however under the $100,000 exception since her net investment income is less than a thousand the government says it's immaterial don't worry about it Mary borrowed $25,000 her borrowing net investment income is zero to purchase a business guess what a hundred thousand less than a hundred thousand dollar it's the hundred thousand dollar exception apply George borrowed 95,000 the borrower net investment income is 15 to buy a home now we have less than a hundred thousand and we have more than a thousand but less than 100,000 but we have net investment income of 15,000 what do we have to do for George well we have to compute the the compute the interest and it has to be we're gonna the interest imputed is the lesser of 15,000 and the interest computed using the federal rate so it's going to be 95,000 times 10 percent times one half which is because the interest is computed semi-annually that's four thousand seven hundred and fifty ninety nine thousand seven fifty times ten percent times one half or six twelve four thousand nine hundred eighty seven dollars and fifty cent the total interest imputed is nine thousand seven hundred thirty seven dollars and fifty cent now far hat the amount of the loan is one hundred and thirty thousand it doesn't matter we stop it's more than a hundred we're going to impute the interest one hundred thousand times ten percent times one half let's go back to the slide so for far hat one hundred thirty thousand times ten percent times one half that's six thousand five hundred then we're gonna take this amount since it's semi-annually added to the one thirty it's going to be one thirty six five hundred times ten percent times one half say one half and six twelve are the same because the interest is semi-annually that's six thousand eight hundred twenty five the interest is sick and total imputed interest thirteen thousand three twenty five because it does not really matter it's above a hundred thousand we don't have to worry about the borrower net investment income so i hope this illustration kind of consolidated the knowledge about imputed interest what should you do now go to far hat lectures whether you are a cpa ea or an accounting student farhatlectures.com to look at additional resources that is that's going to help you understand this topic good luck study hard