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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 a 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. Why? Actually a tax disaster waiting to happen.
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 be beat up with 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 corporate liquidation. Sorry, both are subject to a second tax. A transfer of the property directly to the stockholders also triggers a double tax.
So what’s the answer? Let’s use a typical business owner (Joe), who is married to Mary, as an example. At the time the real estate is purchased Joe should take title in a limited liability company (LLC) and then lease it to his operating corporation. Here are some of the tax and other 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).
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 that price. Yes, 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 has many tax and non-tax benefits. For example, a $1 million piece of real estate transferred to a FLIP will receive a discount for estate tax purposes of about $350,000. The estate tax savings (using 2014 rates) could be as high as $140,000.
6. The LLC acts as an asset protection shield. Should a lawsuit, because of the real estate in the LLC, threaten (or actually) exceed the value of the real estate, Joe’s other assets are protected.
One more point: Do you now have valuable real estate stuck in a corporation? There is an easy way out of the tax trap. But unfortunately, exactly how to get it out of the corporation varies with your specific facts and circumstances. So, if real estate in your corporation is giving you a tax headache, please call me (847-674-5295) and I’ll walk you through what and how to do.
Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman, Kallick, Bartelstein LLP and chairman emeritus of the New Century Bank (both in Chicago). Want to consult, need a second opinion? Call Blackman at (847) 674-5295. E-mail him at firstname.lastname@example.org or visit www.estatetaxsecrets.com.
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