Tax Secrets: Who should own your business real estate?
Your author has often thought of writing a Bible of taxation. Can you guess what the first commandment will be? “Thou shalt not put real estate into a corporation.”
We see this tax-expensive real estate (in a corporation) mistake at least a dozen times a year. When readers of this column ask us to do a tax consultation (usually for business succession/estate planning), we find the business real estate in a separate C corporation (sometimes an S corporation) and leased to the operating corporation. Wrong! Or the real estate is in the operating company (either a C corporation or an S corporation that once was a C corporation). Also wrong! Actually, all are 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 your C corporation, you will run straight into a huge double tax. Again, why? Well, the first tax hits 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 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 second tax at the stockholder level. (Note: Sometimes an S corporation can avoid the second tax.)
So, what’s the answer? Imagine a business owner (Joe) who is married to Mary. Joe should take title (in his name or an LLC) at the time the real estate is purchased. Here are some of the tax goodies that can come Joe’s way (just by taking title the right way) over time:
When Joe retires, the rent he collects is not subject to the social security tax (or other payroll taxes), nor does the rental income interfere with his social security benefits.
Joe can borrow (tax-free) against the property if he needs cash.
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 can make a tax-free exchange for another piece of real estate.
When Joe dies, his heirs get a raised basis. Say Joe bought the property (land and building) 27 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 $520,000. Now, get this – that built-in $500,000 of profit escapes income tax and/or capital gains tax. Forever!
Thank you marital deduction. And try this – Mary now owns the real estate (free of income and estate taxes) with a brand new tax basis of $520,000. Just as if she had bought the property for that price. Yes, she can depreciate the property using her new $520,000 (of course, excluding the land) tax basis, which will shelter a portion of her rental income.
And, oh, yes, when Mary dies, the law allows her to repeat the raised-tax-basis trick all over again when she leaves the property to the kids... two terrific tax breaks, with zero out-of-pocket cost. Wow!
One more point: If you goofed and have valuable real estate in your corporation (C corporation or S corporation), there are a number of easy-to-do-tax tricks to get the real estate out of your corporate tax trap. The exact method depends on your exact facts and circumstances.
Call me (Irv) at, 847-767-5296, and I’ll walk you through the possibilities. Or email me (firstname.lastname@example.org). Don’t forget to include all numbers where you can be reached.