On too many occasions, I have been asked by clients to help them solve problems attributable to the vehicle through which they chose to acquire real estate. Although sometimes such problems can be mitigated, there certainly is no substitute for good front-end planning. This article discusses a few of the many situations where choosing the right ownership vehicle at the time of purchase can prove beneficial when real estate is sold.
Ownership of Real Estate Used in a Business. With the recent rise in the popularity of office condominiums, ownership of real estate by business owners certainly has increased, perhaps dramatically. It is important, therefore, to be aware of a very common tax planning mistake often made by business owners who acquire real estate.
Here is the situation: John Smith operates his business through a corporation, Smith, Inc. John locates the ideal building for his business and causes Smith, Inc., to purchase the building. The business thrives and the building triples in value. John allows his key employee, Carl, to become a shareholder in Smith, Inc. At some point, a potential buyer makes a very attractive offer to purchase the building. John and Carl now face a difficult tax situation. Smith, Inc., will be required to pay tax, at regular corporate rates, on the gain from the sale. If, after paying its corporate income tax, Smith, Inc., distributes the remaining sales proceeds, John and Carl will be required to pay tax on the distributions they receive, this time at long-term capital gain rates. The combined corporate and individual tax rate for John and Carl likely will exceed forty percent.
What could John have done differently? If John had purchased the building through a limited liability company, he then could have caused the limited liability company to rent the building to Smith, Inc., with the following advantages: First, and foremost, the effective tax rate upon the sale of the building would be dramatically lower. Second, the rent paid by Smith, Inc., would reduce its taxable income, thereby decreasing the need to pay compensation to John and Carl in order to avoid corporate level tax. Although the rental income received by the LLC would be taxable to John and Carl, rental income, unlike compensation, is not subject to Social Security or Medicare tax. Third, at the time John chose to allow Carl to become an owner in the business, he would have had the flexibility to retain 100% ownership of the building. That could prove especially valuable for retirement planning purposes. Fourth, if the business subsequently floundered, creditors of Smith, Inc., generally would not be able to seize the building in order to satisfy their claims, as they could if the building were owned by Smith, Inc.
Joint Tenancy With Right of Survivorship? In many Arizona real estate transactions, it seems, married couples take title as joint tenants with the right of survivorship. Almost always, that is not the best choice tax wise. When a married couple owns real property as joint tenants, it is assumed that each spouse owns his or her joint tenancy interest as sole and separate property. Under current estate tax law, the cost basis of property owned by an individual is “stepped up” to fair market value upon the individual’s death. In other words, the unrealized gain on the property effectively is eliminated. This gain elimination applies not only to an individual’s sole and separate property, but also to community property in which the individual has an interest. Thus, by titling property in joint tenancy rather than as community property, a married couple may forfeit the ability to achieve complete elimination of capital gain upon the first of their deaths.
Here is an example of how this works: Suppose husband (H) and wife (W) purchase a rental property for $200,000. In the years preceding his death, H and W claim $100,000 of depreciation on the property. At the time H dies, the property has a value of $400,000 and an adjusted cost basis of $100,000. If the property were titled as community property or community property with right of survivorship, the entire $300,000 gain would be eliminated upon H’s death. If H and W took title to the property as joint tenants with right of survivorship, however, only $150,000 of gain would be eliminated upon H’s death.
Anticipating the Future Like-Kind Exchange. Ordinarily, when two or more individuals purchase investment real estate, they choose to own the real estate through a limited liability company or partnership. For the most part, that is perfectly appropriate. There is one potential pitfall to be considered, however. If it is possible that upon the ultimate sale of the investment real estate, some of the owners would desire to enter into like-kind exchanges, whereas others would desire to cash out, the limited liability company or partnership could be problematical. For example, suppose George and Henry each contribute $100,000 to a limited liability company that purchases an investment property for $200,000. After the property has doubled in value to $400,000, George and Henry decide to sell. George desires to reinvest his share of the proceeds through a like-kind exchange, whereas Henry desires to cash out. If the limited liability company sells the property and distributes $200,000 to Henry, however, the entire gain now is taxable, even if the remaining $200,000 is reinvested.
Here’s an alternative: George and Henry simply take title to the property as tenants in common. When it comes time to sell, each can sell his tenancy in common interest to the buyer. George can enter into a like-kind exchange and defer up to 100% of his share of the gain. Henry can cash out and recognize his share of the gain. A word of caution: The IRS may treat tenants in common as having formed a partnership for income tax purposes. You, therefore, should consult your tax advisor before employing this structure.
Conclusion. When purchasing real estate, the choice of ownership vehicle should be considered carefully. The best ownership vehicle is not necessarily the one that is most easily implemented at the time of purchase. Rather, it is the vehicle that will yield the best results while the property is operated and when it ultimately is sold.
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This article contains only general information and is not to be relied on as legal advice. For advice on your individual situation, consult a lawyer in your jurisdiction. No attorney/client relationship arises from use of this article.