What to Do with Business Real Estate
Holding it within the operating company or in a separate company is not the best solution, tax-wise.
The first commandment of my someday-I-will-write-it bible of taxation will be “Thou shalt not put real estate into a corporation.”
We see it at least a dozen times a year: Business owners consult with us on taxes, usually related to business transfer or succession or estate planning, and we find they have business real estate that is held in a separate C corporation (or sometimes an S corporation) and then leased to the operating company. Often, the real estate is even owned by the operating company. Both of these situations are the wrong approach—a tax disaster waiting to happen.
The reason these approaches to handling business real estate are ill-advised is that when the business owner tries to get that real estate out of the corporation, the company will be beaten up by taxes—twice. The real estate’s actual value invariably will have appreciated, but its tax basis will have depreciated.
The first tax will hit the corporation when the real estate is sold (or transferred to the stockholders). Then the proceeds from the sale will be stuck inside the corporation with only two ways to get those proceeds out: via stock dividends or a corporate liquidation. And both of these will be subject to a second tax. (Transfer of the property directly to the stockholders also triggers a double-tax scenario.)
An Easy Solution
So what’s the answer? Let’s use Joe, a typical business owner, as an example. When Joe
wanted to purchase business real estate, we advised him to take title in a limited liability
company (LLC) and then lease the property to his operating corporation, Success Co. Here are some of the tax benefits and other goodies that can come Joe’s way over time thanks to this strategy:
1. When Joe retires, the rent he collects for the property is not subject to Social Security or other payroll taxes.
2. Joe can borrow tax-free against the property if he needs cash.
3. If he later chooses to sell the property, the sale 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 in what’s called a “1031 exchange” (Section 1031 of the U.S. Internal Revenue Code).
4. When Joe dies, his heirs get a higher, adjusted tax basis. For example, say Joe bought the property 25 years ago for $100,000 and it has now fully depreciated to $20,000 (the cost of the land). The value of the property at his death is $620,000. That $600,000 of profit escapes income taxes forever. Joe’s widow, Mary, becomes the owner of the real estate (free of income and estate taxes) with a new tax basis of $620,000, just as if she had bought the property for that price. She can depreciate the property (except for the value of the land) using her new $620,000 tax basis, which will shelter her rental income.
5. Joe’s interest in the LLC can be transferred tax-free into a Family Limited Partnership (FLIP), which itself has many tax and non-tax benefits. For example, a $1-million piece of real estate transferred to a FLIP will receive a “discount” of about $350,000 for estate tax purposes. The estate tax savings at 2014 rates could be as high as $140,000.
6. The LLC acts as an asset protection shield. Because it is considered a separate legal entity, Joe is not personally liable for the LLC’s debts or legal liabilities. The LLC’s legal liabilities are limited to the assets in that LLC. So if, for example, damages in a lawsuit against the LLC were to threaten or exceed the value of the real estate, Joe’s other assets would be protected.
If you have valuable real estate stuck in a corporation, there are ways out of the tax trap. How you get the real estate out of the corporation varies depending on your specific circumstances. A tax expert should be able to walk you through how to do it.