The first commandment of my someday-I-will-write-it bible of taxation would be “Thou shalt not put real estate into a corporation.”
We see it at least a dozen times year: When readers of this column ask us to do a tax consultation (usually for transfer/succession/estate planning), we find the business real estate in a separate C corporation (sometimes an S corporation) and leased to the operating corporation. Often, the real estate is owned by the operating corporation. Wrong! All are wrong. Actually a tax disaster waiting to happen. Why?
Someday, when you try to get the real estate (invariably, depreciated down to a low tax basis and appreciated in value) out of the corporation, you will run straight into a double tax. Again — why? Well, the first tax will hit the corporation when the real estate is sold (or transferred to the stockholders). Problem is, the sales proceeds are stuck inside the corporation and there are only two ways to get at those proceeds: Via a dividend or a corporation liquidation. Sorry, both are subject to a second tax. A transfer of the property to the stockholders also triggers a double tax.
So what’s the answer? Imagine a business owner (Joe) who is married to Mary. Joe should take title at the time the real estate is purchased and then lease it to his operating corporation. Here are some of the tax goodies that can come Joe’s way over time:
1. The rent Joe collects is not subject to social security tax (or other payroll taxes), nor does the rental income interfere with his social security benefits.
2. Joe can borrow (tax-free) against the property if he needs cash.
3. A sale of the property is subject to only one capital gains tax, which Joe can report on the installment method if he takes back a mortgage for a portion of the purchase price. Joe might even exchange it tax-free for another piece of property (called a “1031 exchange”).
4. When Joe dies, his heirs get a raised basis, for example: Say Joe bought the property 25 years ago for $100,000, and it is now fully depreciated down to $20,000 (the cost of the land). The value of the property on his date of death is $620,000. Now get this — that built-in $600,000 of profit escapes income tax. Forever! And also this – Mary now owns the real estate (free of income and estate taxes) with a brand new tax basis of $620,000. Just as if she had bought the property for the $620,000 price. Yes, she can depreciate this property (except for the value of the land) using her new $620,000 tax basis, which will shelter her rental income.
5. The property can be put into a Family Limited Partnership (FLIP), which has many tax and non-tax benefits. For example, a $1 million piece of real estate transferred to a FLIP can receive a discount for estate tax purposes of about $350,000. The estate tax savings could be as high as $157,500 (using current estate tax rates).
And, oh yes, when Mary dies, the law allows her to repeat the raised-tax-basis trick (to raise the value of the property at her death) all over again when she leaves the property to the kids.
Now you know why owning real estate in a corporation is not only a tax trap, but it also prevents you from reaping a tax harvest during your life, at your death and beyond.
Want to learn more tax tricks that will save you a bundle? Take a peek at my Web site: taxsecretsofthewealthy.com.
Irv Blackman is a certified public accountant who lives part-time on Marco Island and specializes in estate planning, business succession and asset protection. E-mail him at email@example.com or call 417-9732. His Web site is taxsecretsofthewealthy.com.