Avoiding ordinary income treatment on the sale or exchange of depreciable property between related parties.

Facts Bill owns a vacation home in an area in which his son-in-law, Carl, practices medicine.

Carl incorporated his medical practice several years ago, and owns all of the corporation's stock. Two years ago, he began selling medical supplies and equipment. This operation was incorporated separately, owned 40% by Carl and 60% by Bill.

Carl is considering having one of the corporations purchase Bill's vacation house for use as a new office or a store. Bill will recognize a substantial gain on the sale. If the sale receives capital gain treatment, Bill has large capital losses that can be used to offset the gain.

Issue

Can the salc be structured so that Bill will recognize capital gain?

Analysis

Gains recognized on sales or exchanges between related persons are treated as ordinary income if the buyer can depreciate the property. Related persons for this rule include an individual and a corporation or a partnership, if the individual owns more than 50% in value of the corporation's stock or the partnership's capital or profits interest; two corporations that are members of a controlled group (as defined in Sec. 267(f)); a corporation and a partnership, if the same individuals own more than 50% in value of the corporation's stock and of the partnership's capital or profits interest; two S corporations, if the same individuals own more than 50% in value of each corporation's stock; or a C corporation and an S corporation, if the same individuals own more than 50% in value of each corporation's stock. (The more-than-50% test is based on the value of the stock owned, rather than its voting control.)

These rules apply to property that can be depreciated by the purchaser, even if not depreciable by the seller. The gain is ordinary even if the purchaser chooses not to depreciate the asset or elects to use an alternative method of expensing. If a sale or exchange includes both depreciable and nondepreciable property, the gain is allocated; only the portion allocable to the depreciablc property results in ordinary income.

The related persons determination is made based on thcir rclationship at a certain time. If a corporation is the seller, the test is satisfied if the parties are related either immediately before or after thc sale. If an individual sells the property, the determination is made immediately after the transfer. Two entities are related if the same persons own more than 50% of the transferor immediately before and more than 50% of the transferee immediately after the sale.

It should first be determined if the property to be sold is the type that will require rccognition of the gain as ordinary income. Bccause the vacation home will be depreciable property to either corporation, the gain allocated to it will be recognized as ordinary income if it is sold to a related person. The fact that thc vacation home was not depreciable property in Bill's hands does not affect this determination.

The tax adviser should then determine if Bill would be considered related to either of the corporations: Carl's 100% interest in the professional corporation would be attributed to his wife (Bill's daughter). However, this interest would not be reattributed to Bill from his daughter. Consequently, Bill would not be considered related to the professional corporation. In contrast, Bill would be considered rclatcd to thc salcs corporation because he directly owns more than 50% of it.

Conclusion

The portion of Bill's gain associated with the vacation home will be treated as ordinary income if the sales corporation purchases the property. The property will be depreciable by the corporation, and the portion allocable to the land will be capital gain. Alternatively, even though the property will be depreciable by the corporation, all of Bill's gain will receive capital gain treatment if Carl's professional corporation purchases the property.

By having thc professional corporation purchase the property, Bill will be able to use capital losses to offset his gain on the sale.

If thc propcrty is sold to the sales corporation, Bill's gain allocable to the land is capital gain. The tax adviser should establish a valid purchase price allocation to reduce the gain on depreciable assets. Of coursc, thc purchasing corporation would then be forgoing depreciation on the increased amount allocated to the land.