For many reasons tax attorneys may think it desirable to keep real estate out of a corporation. The transfer or sale of assets, such as appreciated assets from a C Corporation leads to double taxation issues that are not found when the real estate is owned by individuals or a partnership. Even when a C Corporation distributes real property to a shareholder there are double taxation issues. The article below, drafted by a Denver tax attorneys outlines a few issues to consider if you operate as a C Corporation.
Generally real estate appreciates in value creating more built in gain. Further, as the real estate is depreciated, the built in gain is increased by the depreciation taken and as time passes, a large gap grows between the fair market value of real estate and the adjusted basis. This creates even more gain to be recognized by the corporation when the property is sold, distributed or transferred.
Although, a section 1031 like kind exchange may be an option for transferring real estate out of a corporation, a partnership is likely to provide more flexibility, as the partnership may be able to transfer out an undivided interest in real estate to each partner who can then sell or transfer their share.
An additional issue to consider is exposure and asset protection. When real estate is held in a corporation it is subject to the claims of creditors. Therefore, it may be better to hold the property individually or in a partnership such as an LLC.
When analyzing the sale or transfer of property from a corporation, the analysis should include considerations at both the corporate and shareholder level. Regarding the gain at the corporate level, a C Corporation will be taxed at the C Corporation tax rates on any gain. A common problem arises when a C corporation distributes property to a shareholder as is thereafter taxes, but the corporation lacks the cash to pay the tax. An S Corporation may still be taxed at the corporate tax rates for any built in gain to the extent there was built in gain when the S Corporation made the S Election. If the S corporation has no built in gain, the gain will pass through to the shareholders and taxed at the shareholders applicable tax rates thus avoiding double taxation.
If the property is sold for fair market value to a shareholder, as opposed to distributed as a dividend, there will be no tax at the shareholder level. The shareholder’s basis in the real estate would be the purchase price. If the property were distributed to the shareholder from a C corporation, the fair market value (less any debt on the property) would be taxed to the shareholders, initially as a dividend to the extent of the corporation’s earning and profits. Distributions above earnings and profits would be considered return of capital (return of basis) and thereafter capital gain.
Because of the above tax implications and consequences, the sale or transfer of real estate or liquidation of the corporation creates a large amount of tax due and may not be practical. A business considering the sale or transfer of real property should always consult with their business attorney or tax attorney to review all of the implications.