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I'm exploring an option for unwinding a real-estate investment with my step-father. Please assume that we're both amicable towards any viable solution.

My step-father is currently the sole owner of this house due to probate action this year, which provides a value basis. It was initially in my mother's name as an asset before they were married and title was never changed.

For the sake of simplicity, let's assume that the property was purchased for $250k (in 2005) and is now worth $150k (per probate).

If the property is sold at a non-arms-length transaction to me for the current fair value, the actual capital loss would be $100k... But would the IRS agree since the valuation at the probate action was $150k and since it was purchased by my mother prior?

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But would the IRS agree since the valuation at the probate action was $150k and since it was purchased by my mother prior?

The IRS will not agree, but not for the reason you think.

Your father selling the house to you is what is called "related persons transaction". There are very clear rules as to who recognizes the loss, and when.

Assume your father has basis of $250K in the property. He sells it to you, his son, for $100K. I.e.: within your family, without transferring the asset outside of your family's control, you generated a huge $150K loss. It would be reasonable for lawmakers to identify these transactions as a tax evasion scheme and disallow them. Which they did.

So in this scenario (father selling a house with basis of $250K to his son for $100K), the loss of $150K cannot be recognized for taxes. I.e.: father will not deduct the loss on his tax returns. Instead, you (the son) will carry the the loss forward. When you sell the property, you'll deduct that loss from whatever gain you're going to have. Unless you sell it to your son, which would disallow the loss again. You get the picture.

Get back to your scenario: your father has a "stepped-down" basis. I.e.: since the property was owned by his wife, when she passed away he gained control of it as part of the inheritance. His basis is the value at the time of death (or 6 months after). I.e.: in your scenario, father's basis is $150K, not $250K. So by selling to you at FMV - he's not generating any loss at all (which makes things simpler for you since there's no disallowed loss to carry forward until you sell the property).

Talk to a licensed tax adviser (EA/CPA licensed in your State) about the details.

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    Would the $100K capital loss have disappeared without any benefit of it being claimed? Would the estate have been able to use it?
    – Chris W. Rea
    Commented Nov 10, 2014 at 13:22
  • No capital has been lost. The house, and the money, have changed hands within the family; the family still has all of both. (If they DID let you claim this as a loss, they'd also insist on taxing you on the additional $150K of value you've gained by getting the house at a discount; your cost basis on the house would now be only $100K. It balances out...)
    – keshlam
    Commented Nov 10, 2014 at 16:07
  • I read the IRS segment on this. I suspect, actually, that it may not apply since he's my step-father and not actually an "ancestor" per the IRS guideline. So then the second part, his stepped-down basis, where does that realized loss go?
    – Matthew
    Commented Nov 10, 2014 at 16:53
  • @Matthew into the abyss I guess. As to "ancestor" - I believe step-children are included in some of the related party rules. Depending on whether you were legally adopted.
    – littleadv
    Commented Nov 10, 2014 at 16:58
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    @ChrisW.Rea no, estate wouldn't be able to use it since estate tax is on the value, not gains. It is lost, the same way that the "gain" from stepped-up basis is not taxed.
    – littleadv
    Commented Nov 10, 2014 at 17:00

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