If you are planning to own investment real estate, there is one simple but critical rule you must adhere to:
Never hold your real estate inside a corporation.
This is one of the worst tax decisions you can possibly make and can cause big problems if you decide to sell or refinance your property. If you are thinking of, or have received advice advocating putting your real estate in a corporation, you should continue reading to learn ten compelling reasons not to do so.
- Double taxation. If you hold real estate in a C-Corporation, you will face double taxation if the property has appreciated in value and you decide to sell it. The corporation will pay a tax when the appreciated property is sold and the shareholders will pay a tax when the proceeds from the sale are distributed to them. Likewise, if the corporation decides to distribute the property directly to the shareholders, this will be treated as a sale under the IRS deemed-sale rules of Section 311(b) and both the corporation and shareholders will still have to pay their share of tax if the property has appreciated in value.
- No capital gains tax rate available to C-Corporations. The preferential 15% capital gains tax rate available to individuals is not available to C-Corporations. Any gain on the sale of real estate by a C-Corporation will be taxed at the corporation’s regular tax rate, which can be as high as 35%.
- All shareholders must be included in a 1031 exchange. A 1031 exchange is a viable tool for real estate investors. However, if a corporation that owns real estate wants to enter into a 1031 exchange, the election must be made at the corporate level with all of the shareholders on board. This can cause problems when some shareholders are not in favor of entering an exchange.
- Rental losses in a C-Corporation are not deductible by the shareholders. Rental losses from real estate owned by a C-Corporation must be kept “inside” the corporation. The losses generally may be carried back two years to reclaim a portion (or all) of corporate taxes paid in those years. If there are no taxes to reclaim in the prior two years, the losses may be carried forward 20 years and offset future income of the corporation, including income from the sale of the property. However, the losses do not provide any tax benefit at the shareholder level.
- You may have a difficult time selling your company. If you decide to sell the stock of your corporation, you will likely run into resistance from potential buyers if there is real estate inside of it. Buyers will generally not want to buy the stock of a corporation that owns real estate because they will not get a step-up in basis for the real estate and they will also be responsible for any mortgages on the property owed by the corporation. Buyers will usually want to buy the real estate only, which may lead to double taxation as described in item #1 above.
- Refinancing a property owned by a C-Corporation and cashing out will create a taxable event. If a C-Corporation refinances its property and distributes the proceeds to its shareholders, this will create a dividend that is non-deductible by the corporation and taxable to the shareholders.
- No step-up in basis for your beneficiaries. If you own real estate individually or through a partnership, your heirs may inherit the real estate at its fair market value when you die (this is known as a step-up). They can then sell the property without incurring any (or very minimal) capital gain. However, if you die owning shares of stock of a corporation that owns real estate, there is no step-up available for the real estate. The shares of stock will be passed on at their fair market value, but the real estate inside the corporation will not. If you heirs want to sell the real estate, they will either have to sell the stock of the corporation (which can be difficult—see item #5 above) or will likely incur double taxation if they sell the real estate separately.
- No debt basis for third-party loans made to an S-Corporation. Unlike partners in a partnership, S-Corporation shareholders do not receive debt basis for loans made by a third party to their corporation. The only way the shareholders can acquire debt basis is to personally make loans to the corporation. Even a personal guarantee of a third party loan will not give a shareholder debt basis. And since basis (both stock basis and debt basis) is the driving force in determining the taxation of distributions and the deductibility of losses, not receiving any debt basis from third party debt is a major disadvantage for S-Corporations holding real estate. S-Corporations cannot refinance their properties and distribute the proceeds to the shareholders tax-free unless the shareholders have adequate stock basis or debt basis. Since the shareholders receive limited tax benefits from leveraging the real estate inside an S-Corporation, this scenario is unappealing for real estate investors.
- The Built-In Gains (BIG) tax. If a C-Corporation that owns appreciated real estate elects S-Corporation status and sells those assets at a gain within ten years of making the election, the corporation will be liable for the built-in gains (BIG) tax. Built-in gains are taxed at the maximum C-Corporation tax rate of 35%. The calculation of the tax can be complicated and is affected by other factors such as built-in losses and the corporation’s taxable income. Care must be taken by C-Corporations electing S-Corporation status to ensure that the corporation will not be hit with the BIG tax.
- The Personal Holding Company (PHC) tax. A C-Corporation with rental income may face the PHC tax if it does not make regular dividend distributions to its shareholders. Undistributed PHC income is taxed at the rate of 15% and this tax is computed in addition to the corporation’s regular income tax.
If you are planning to own investment real estate, especially with partners, the real estate should ideally be held in a limited liability company, a limited partnership, or, if a large number of investors and properties are involved, a real estate investment trust. Nevertheless, if you are a shareholder of a corporation that owns appreciated real estate, care must be taken to determine the best way to resolve the situation with the least amount of tax exposure at both the corporate and shareholder levels.
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