Monthly: February 2016

Never hold investment real estate in a corporation

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.

  1. 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.
  2. 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%.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. 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.
  10. 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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Would you pay to not have to wait on hold with the IRS? California startup enQ thinks that you would. Their business model is to snag slots in the front of the IRS call center queue and sell them to individuals who need to call the IRS. It’s kind of like paying someone to wait in line to buy the new iPhone, but this is paying extra for something that you don’t want to do in the first place.

Apple security setting stonewalls the FBI

As you may have heard, the FBI and Apple are at a technological standoff. The FBI wants to gain access to the information stored on the iPhone 5C of Syed Farook, one of the shooters from the San Bernadino attack in December. The FBI doesn’t have the passcode for the iPhone and cannot access the data.

The FBI computers can attempt to crack the passcode, but after 10 unsuccessful attempts at entering a passcode on an iPhone, a security setting wipes the iPhone data clean. This is obviously making the FBI hesitant about trying different codes as they don’t want to risk losing the very data they are trying to obtain.

Unable to find a way around this security measure, the FBI states they asked Apple for help in overriding the security settings. Tim Cook, CEO of Apple, refused. On Tuesday, a federal judge in California ordered Apple to provide “reasonable technical assistance” to the FBI in accessing to the encrypted data on the iPhone. Tim Cook still said no.

One of the most interesting aspects of this case is that the Justice Department is relying on a 227-year-old statute to get Apple to comply with their request. The All Writs Act from 1789 essentially gives courts the authority to issue orders that do not fall under pre-existing laws. The government frequently uses The All Writs Act to obtain wiretaps, emails, computer passwords and security camera footage. There is precedence for Apple to refuse this, specifically because the device in question is not the property of nor under the control of Apple. Apple continues to assert that the government is trying to use the Act to force Apple to unlawfully perform forensic services on the phone to obtain the information.

There are valid arguments on both sides of this issue and the case bears watching as it could be a landmark decision in the cyber security world. In the meantime, be sure you don’t allow a toddler to keep entering passcodes on your iPhone in an attempt to access their favorite Peekaboo Barn app.

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“Success is nothing more than a few simple disciplines, practiced every day.” – Jim Rohn

IRS hackers are at it again

In last week’s post, I discussed my concerns about security breaches that may result from the Internal Revenue Service’s plan to start emailing and texting taxpayers.

That initiative hasn’t become a reality yet, but the identity thieves have been hard at work. In a statement released yesterday, the IRS informed us that they halted a malware attack on their servers. The statement indicated that hackers deployed a bot (an automated software application) that used stolen social security numbers obtained elsewhere and attempted to match the social security numbers to e-file PIN numbers and access taxpayer data. E-file PIN numbers are used to electronically sign e-filed tax returns. In most cases, the PIN numbers are randomly generated by tax software unless a taxpayer wants to use a specific PIN number.

The IRS says that no personal taxpayer data was compromised or disclosed by the IRS systems. Affected taxpayers will be notified by the IRS that their personal information was used in an attempt to access the IRS applications. The IRS will also the flag the social security numbers to prevent tax-related identity theft.

Please note that if you are one of the affected taxpayers, the IRS will be notifying you about this incident by regular mail and not by email. If you get an email about this (or about anything) from the IRS, please do not open any links in the email and discard it immediately. As I have stated before, the IRS currently does not communicate with taxpayers via email under any circumstances. Unfortunately, this latest incident will create opportunities for these scam artists to send fake emails to taxpayers about a real event that occurred. Be on the lookout for these type of fake emails.

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By all accounts, Cam Newton had a bad Superbowl. But to make matters worse off the field, because of Newton’s contract and how professional athletes are taxed by the various states they play in, Newton will owe approximately $101,000 in California income taxes on the $51,000 he earned for being on the losing team in the Superbowl.

It sounds good in theory, but….

In its 2015 annual report to Congress, the IRS unveiled its vision for the future, which includes initiatives such as:

  • Allowing taxpayers to access their account information online
  • Allowing taxpayers to update and amend returns online
  • Curtailing phone communications and face-to-face meetings and corresponding with taxpayers via email and text

While I am all for these technological advancements and reducing IRS hold times on the phone, the last item concerns me greatly. There are a lot of phishing scams where taxpayers receive emails that look like they are from the IRS. These are easy to toss in the trash folder because currently, the IRS never communicates with taxpayers via email or text. If you receive an email now that looks like it is from the IRS, you can immediately junk it because it is spam 100% of the time. However, if the IRS does start emailing or texting taxpayers for real, the scam artists will have an easier opportunity to fraudulently collect information from taxpayers who will have to decipher between real and fake emails.

Granted, the IRS phone system is awful – last year 60% of people who tried calling the IRS couldn’t get through at all. And the IRS does plan to enhance their manpower in their call centers (although I am not expecting much from them). But moving to an email/text communication platform creates some serious vulnerabilities that can cause much more harm then good. IRS identity theft is already at an all time high and I would hate to see it get worse.

We’ll see how this unfolds. As with most things IRS related, this will probably take a few years and several iterations before it become a reality.

Here is one of my favorite anecdotes about business development:

Two shoe salesmen were dispatched to the Australian Outback to sell shoes to the Aborigines. Shortly after arrival, the first salesman called his sales manager and said, “This is useless. There are no sales opportunities here. These people don’t even wear shoes!” A few minutes later, the second salesman called in and said, “This is great! There are so many sales opportunities here. These people don’t even wear shoes!”

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