A dilemma every real estate investor who buys and sells property for short term gain faces, is how to proceed if the property does not sell. Most of my clients understand the importance of using a corporation for their short term investing to avoid the dreaded “dealer” classification. This usually requires the utilization of a corporation to keep “dealer” type activity separate from long term “investor” activity. When the short term quick flip property becomes a long term investment, what is the individual to do? For most investors who own a corporation the answer seems simple enough – pull the property out of the corporation and contribute it to an LLC for asset protection. However, this can create a serious problem if not properly structured. I can assure you many investors have made this same mistake, but have not been caught. Here is the story of Mr. and Mrs. Cezar, the couple who serves as the example of what happens if you get caught.
Mr. and Mrs. Cezar were the sole shareholders of RVJ Cezar Corporation, which built “spec” houses that it sold to the public. In 2004, they finished a home and offered it for sale, but there were no takers. Presumably because of no buyers, the Cezars, transferred the home out of their corporation to their personal names. At the time, the house had a total fair market value of $920,000. The Cezars did not report the receipt of the home on their return for 2004, nor did the corporation report the distribution of the home on its return for 2004.
How Did This Happen
The general rule is when a corporation distributes appreciated property to a shareholder it recognizes gain as if the property were sold to the shareholder at its fair market value and the shareholder recognizes gain on the dividend. On audit, the IRS determined that the distribution of the home was a constructive dividend from the corporation. It determined that the Cezars received a qualified dividend and treated the value of the home as long-term capital gain. (The Cezars were somewhat fortunate because this event occurred in 2004. In 2011 dividends will be taxed as ordinary income rather than long-term capital gains.) FURTHER, their corporation recognized gain on the difference between its cost basis in the property and its $920,000 value. DOUBLE TAXED…To add salt to the wounds, the Tax Court also hit the Cezars and their corporation with an accuracy related penalty for the underpayment of income tax attributable to negligence or disregard of rules and regulations.
How to Avoid This Problem
If you find yourself in Mr. Cezer’s position you may consider leaving the property in the corporation and writing it up to a deal that just didn’t pan out as you expected. Another solution would be to personally pay for the property and contribute it to your corporation. Further, you could personally pay for the property’s improvements thus, creating sufficient basis in your company stock to remove the property with minimal tax consequences.