Do you have real estate owned in your corporation? Watch out for a tax surprise!
Many of you have heard from your advisors (including yours truly) that if you own real estate either for your business or for investment then you need to protect yourself from liability by having the property titled in some form of corporate entity; see my June newsletter. However, it is very important that you choose the right type of entity to own your real estate. As a general rule, you should not use a corporation. Why? Corporate tax law is not friendly to the real estate owner.
I will spare you a lengthy discourse on the ins and outs of corporate tax laws, although I assure you that it’s fascinating! The short answer is that real estate owned inside of a corporation generates an unexpected tax liability if you ever wish to move that property out of the corporation. Let’s say that you acquire a couple of rental properties with a friend and you set up a corporation as the owner, but some years later you and your friend decide to part ways and split up the properties. This would typically involve dissolving the corporation and transferring property out to each owner. The problem is that the tax law treats that transfer of property as a “deemed sale.” If the property has appreciated then that deemed sale triggers a capital gains tax for the corporation. It is irrelevant that you haven’t actually sold the property or that no cash has changed hands.
For this reason, you should avoid using a corporation to own real estate in most cases. Keep in mind that I am talking about real estate that you buy and hold (e.g. a location for your operating business, rental or investment property). If, on the other hand, you are in the business of buying and selling real estate on a short term basis, then a corporation may work perfectly well for your needs, since you will recognize a tax liability anyway when you sell property; there is not the same potential for a deemed sale surprise.
Enter stage left….the limited liability company (LLC). An LLC is typically taxed as a partnership, which operates under entirely different tax rules. In particular, real estate can almost always be moved in and out of the name of an LLC without generating a tax liability. Since the LLC still provides the same basic limited liability protection available in a corporation, the LLC has become the entity of choice for owning real estate.
What about an “S” corporation? An “S” corporation is, in many ways, taxed like a partnership, however one important difference is that the deemed sale rule described above will still apply for an S corporation. Although there may be special circumstances that help decrease this tax liability with an S corporation, the better option is to stay away from a corporation altogether.
If you are unfortunate enough to have a corporation that owns real estate already, then you may be stuck with this potential tax issue until you are ready to sell the property. But please talk to your tax advisors before you take any action; you may have planning options to help minimize the tax liability.
Remember, tax time is no time for surprises.