Corporations get a bad rap in the investor community. This is often seen when an experienced investor who has shied away from corporations tells new investors that you do not need a corporation to start investing in real estate. They will then cite additional reasons as to why corporations are poor choices when undergoing entity structuring for your long-term rentals.
A couple of weeks ago, Chris Clothier wrote an article citing 10 reasons why one should not use a corporation for their rentals. Chris is a very smart guy, and I respect him a lot. Everything he said in his article was accurate, factual, and true. Chris explained why he does not use corporations for his rentals and also touched on when he thinks the use of corporations make sense.
The only problem I have with articles like this — and nothing against Chris — is that it instills a level of fear in a new investor’s mind. Worse, these articles written by successful people, have massive influence over less experience or new investors. This type of knowledge transfer may cause new new investors and less experienced investors to avoid corporations like the plague.
I encourage you to always keep an open mind when you read anything on the internet. Trust, but always verify. You should even verify the articles that I write, even though I’m a licensed professional.
If we only ever consider one side of the coin, we would not be where we are today. Imagine if you listened to everyone that said investing in real estate is a bad idea (there are plenty of these people out there). You likely would not be reading this article today and you would be missing out on a great investment vehicle.
What if somebody told you that raising kids was a horrible idea or that a trip to the Virgin Isles was a bad experience? Would you forgo having kids or ever granting yourself a sweet Virgin Isles vacation?
Always consider the other side of that coin. Consider how a person’s prior experiences may have shaped his/her view, and how that person’s circumstances may differ from your own.
My goal today is to show you the flip side when it comes to using corporations in your real estate strategy. While there are many reasons to use a corporation, I am only going to discuss two. But the key takeaway is that corporations can be powerful tools and you should never swear off a perfectly viable strategy just because it has negative traits. While Chris was right in that corporations have negative traits, those traits can all be mitigated when working with a solid real estate CPA.
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When Placing Rentals in a C-Corporation Makes Sense
As you grow personally and professionally, you will find that your earnings will steadily increase. Of course, higher earnings equate to a higher tax bracket.
When you invest in rental property, especially rental property that performs well, you will likely have additional tax liability caused by the net profits generated from your rentals. If you find yourself in high tax bracket due to your other income sources and you have several well performing rentals, utilizing a C-Corporation may make a lot of sense.
You see, C-Corporations enjoy a 15% marginal tax rate up to $50,000 of net profit. So if you find that you are reporting net positive rental income and your effective tax rate is higher than 15%, you should consider the use of a C-Corporation. I’m not saying it will definitely work out for you, but this option should absolutely be explored.
Many of my high net worth/net income clients utilize a C-Corporation to some degree in their overall real estate investment strategy. Business owners also stand to benefit from a C-Corporation use.
Triggering a Taxable Sale
There are plenty of risks associated with utilizing a C-Corporation. One that Chris cited was the fact that you cannot remove the rental property from the C-Corporation without causing a taxable event. The reason for this is that the IRS considers distributing property from a C-Corporation to its members as a non-cash distribution. This is fancy lingo for a “taxable sale.” We accountants like to make things challenging so that ordinary folks are forced to hire us!
The reason for this is that the members own shares, and the shares of the corporation have a value attached to each. As an example, if you owned shares of Apple and the company issued you a piece of real estate, it would be recorded as a sale to a shareholder.
This is certainly a big problem and can cause unnecessary tax liability. However, as with any tax problem, teaming up with a professional who knows what he or she is doing will allow you to mitigate the risks.
Using a Charitable Remainder Trust
One way to exit a C-Corporation is to use a Charitable Remainder Trust. By transferring the property into a Charitable Remainder Trust, the C-Corporation will not report a sale of the property. Instead, the Charitable Remainder Trust will sell the property and retain all of the cash from the sale. The Trust does not report capital gains and subsequently enjoys maintaining the entire principal balance of the real estate asset that was just sold.
This is a huge planning opportunity. By transferring to a Charitable Remainder Trust, the proceeds from the eventual sale of the property are not taxed at the Trust level, meaning you get to reinvest the full principal balance and watch your net worth grow exponentially. There are caveats, such as declaring a charitable organization and taking minimum distributions that you must then pay taxes on, but avoiding an initial massive tax bill is huge from a wealth planning perspective.
When Placing Rentals in an S-Corporation Makes Sense
I recently assisted one of my clients with the offloading of a property that he was living in as his principal residence. But when I say offloading, I really mean transferring it out of his personal name.
A Real Life Example
To give you some background information, this client was living in a primary residence that he had bought several years ago as a long-term live-in flip. He was sitting on $350k of capital gains.
During our initial consultation, he jokingly told me that his wife wears the pants, and she has decided that it is time to move across town, get a bigger house, and live closer to her family. They are expecting another child, and it is simply time to upgrade.
Before I continue with the story, I should explain the Section 121 exclusion. The Section 121 exclusion allows you to exclude $250k of capital gains from taxes, $500k if married filing joint, if you live in a property and use it as your primary residence for two of the last five years. Once you move out, you have three years to sell the property in order to meet that five-year look back test.
As you can see, you can theoretically live in a property for two years, move out and rent for three additional years, and still sell the property and avoid all capital gains up to $250k or $500k if married filing joint.
Back to the story. My client knew about the Section 121 exclusion and has effectively used it over the past 15 years. He knew that if they moved across town and left their current residence, he would have three years of rental use before he had to sell it to exclude his $350k of capital gains from taxes.
The problem was that my client is bullish on the neighborhood where his property is located. He thinks that over the next decade, the property stands to increase anywhere between 50 to 75% in value. He does not want to get rid of the property within the next three years and wants to hold for the long-term.
At this point, he decided to seek professional help. He wanted to see if there was any way to hold the property for 10 years and still receive the capital gain exclusion when he eventually sold.
Many of you reading are probably thinking, “Well, you can’t get the capital gain exclusion, but you can do a 1031 exchange or simply hold until you pass it on to your heirs.” Those two methods work, but there’s a third, less popularized method that works much better in unique situations.
That is to sell the property to an S-Corporation that you own.
Using the Section 121 Exclusion
By selling the property to your S-Corporation, you will have a qualified sale. This will require that you report the sale on your own tax return. Because you report the sale, you will also be able to utilize the Section 121 exclusion. My client’s tax liability will be nil as a result of this sale.
But it gets better. The S-Corporation now receives a stepped up basis. Basically, because the S-Corporation purchased the property, the S-Corporation’s tax basis in the property is the purchase price or fair market value. This means that we have effectively made the capital gains up until the point of sale “disappear.”
An example will help illustrate. My client’s original basis in his home was $200k (this price he originally purchased it at). His current value is $550k, which means he is sitting on gains of $350k.
When he sells the property to the S-Corporation, he reports capital gains of $350k on his tax returns. But because he has lived in the property as his primary residence for two of the past five years, he can utilize the Section 121 exclusion. Bob is married, so he gets to exclude $500k of capital gains which erases his tax liability from the $350k he reported.
Additionally, the S-Corporation reports the property with a basis of $550k on its books. This means that, in the future when the property is sold, the S-Corporation will pay capital gain taxes on the future net selling price, less $550k.
The “to-date” capital gains have essentially disappeared.
While I hope you took something away from the two strategies outlined above, my larger point is to never disregard a strategy simply because you read an article citing reasons not to do something.
In your real estate investing career, it is imperative that you keep an open mind and analyze all strategies available for your use. Failing to do so can result is massive headaches and missed opportunities.
Do you keep your rentals in corporations? Why or why not?
Weigh in with a comment below!