Taxpayers have the right to minimize their tax liability. The problem arises when they use illegal or prohibited practices to escape their liability. One of these banned methods is known as sham transactions.

The IRS prohibits any transaction that is engaged in for the purpose of evading or avoiding tax liability. Known as sham transactions, these are any sort of deal or transaction used to avoid taxes rather than serving a legitimate business purpose.

There are two general types of sham transactions, factual shams and economic shams. Factual shams are transactions that never took place. Economic shams are transactions without any economic substance.

In determining if a transaction is an economic sham, the IRS will consider two primary questions:

• Did the taxpayer enter into the transaction for a business purpose or anything other than a tax benefit?
• Did the transaction have any practical economic impact other than avoiding taxes?

Those found to have participated in a sham transaction may face penalties, interest, and fines. In some cases, the transaction may become a criminal matter, meaning the possibility of imprisonment.

Sham Transactions and Real Estate Deals

Real estate sales can fall under the sham transaction doctrine. If a report sale didn't occur, that would be a factual sham.

Economic shams can be more difficult to prove, as a 2024 U.S. Tax Court opinion highlights. In this case, the court ruled that the real estate transaction wasn't a sham because the involved parties had entered into a valid Option Agreement. In this case, the court found consideration beyond minimizing taxes by showing actions both parties had taken regarding the property in question. The Option Agreement had a nontax purpose in developing and rezoning the property, among other considerations.

This case highlighted how the actions of parties before and during a real estate transaction can be used to prove or disprove a claim that the transaction was a sham. In this case, evidence was sufficient to show that the transaction had occurred and had a purpose beyond avoiding taxes.

If you have questions about real estate deals and tax liability, call Senior Partner, Tax Controversy Attorney, and former IRS attorney Brandon A. Keim at (602) 200-7399 or contact him online to discuss your options.