Do you have real estate owned by your C corporation? Have you been debating the best method to get it out? How do you minimize the tax impact?
The sale of assets in a C corporation is subject to taxation at C corporation rates, ranging from 15% to 35% federal tax. On the other hand, long term capital gains on the sale of real estate in a partnership, an S corporation, or held outside an entity is taxed to individual owners at 15% for land and gains above original cost and at 25% on depreciation recapture for federal purposes. When the real estate market recovers, this disparity will only be exacerbated. Now may be the time to take action to minimize the corporate gain on the real estate.
By taking action now, you may be able to lock in a lower gain at the C corporation level and allow all future appreciation to escape the higher C corporation tax rates and double taxation. Further, it will likely result in a stepped up basis for the property in the hands of the new entity or individuals. This can result in increased depreciation deductions if you rent the property back to the C corporation and may help to minimize future rental income.
As we have all seen, real estate values have plummeted in the last few years. Since late 2008, real estate values have significantly decreased in many regions, and some advisors believe that we have not reached bottom yet. This may give you a unique opportunity to take steps to pull real estate out of a C corporation and lock in the gain to be recognized at the C corporation level. So, what steps should you take?
There are two primary ways to get the real estate out of a C corporation and still maintain control of the real estate:
1. Distribute the real estate out as a dividend, or
2. Sell the real estate to a related entity or individuals
If you have the option of holding on to the real estate for a sufficient period, there may be a third method which also eliminates the double tax, which is discussed more fully below.
The distribution of an asset from a C corporation to its shareholders is treated as a sale of the asset by the corporation and a distribution of cash equal to the fair market value of the property. As a result, gain is recognized at the corporate level to the extent that the fair market value of the property exceeds the adjusted basis inside the C corporation, and the shareholders pay tax on the dividend amount if the corporation has current or accumulated earnings and profits.
For example, if the property inside the C corporation consists of land and a building originally purchased for $500,000, with accumulated depreciation of $200,000, and it is now worth $1 million, the potential gain on sale or at distribution is $700,000. This would result in a tax of about $280,000 inside the C corporation, and a dividend to the shareholders of $1 million.
To further complicate matters, when an asset is distributed to shareholders there is no cash generated at the corporate level to pay the tax. As a result, a distribution of the real estate can put the C corporation into a cash crunch or force a capital contribution or a loan to the corporation to cover the taxes due at a time when those asked to make the capital contribution have to pay taxes on the dividend. Consequently, most of the time, this is not a viable method of getting real estate out of a C corporation. One instance where it might work is where the corporation has net operating losses or capital losses which could offset the gain at the corporate level. If not, the best method is likely a sale of the real estate to a related entity or individuals.
To facilitate the sale, the related entity or individuals will need to have the necessary cash or be able to obtain a loan to purchase the real estate from the C corporation. If there is a current mortgage on the property, the bank may be willing to transfer the mortgage to the new owners. Unlike a distribution, any gain incurred as a result of the sale can be covered by the corporation via the cash from the sale, and the shareholders are not subject to tax since there is no dividend distribution. As a result, the sale should provide all of the desired results – lock in smaller gain at the C corporation level, move future appreciation outside the corporation and allow for a stepped up basis if the property is to be rented back to the C corporation – while still keeping control of the property.
Considering the economy, the recent decline in real estate values and the detrimental tax rate for real estate sales inside a C corporation, now could be the time to act to limit the gain inside the C corporation. And a sale to a related entity or individual could be the most efficient way to limit taxes now and in the future.
As promised above, there may be a third method of divesting the C corporation of ownership and avoiding double tax completely. If the corporation is eligible to make an S corporation election, the gain at the time of the election is tracked as net unrealized built in gain (NUBIG). If the S corporation sells the asset within 10 years, the corporation pays a C corporation tax on the NUBIG. After the 10 year period passes, the asset can be sold and the shareholders will be entitled to the long term capital gains rate on gains in excess of the depreciation recapture. This holding period was shortened for dispositions in 2009 – 2011, and it is possible it will be shortened again by Congress. If a sale is required before the end of the statutory holding period, only the NUBIG is subject to corporate tax, and accordingly depressed real estate values enhance the benefits of an S corporation election now.
What if the corporation is not eligible to make an S corporation election, for instance, if one of its shareholders is a C corporation? Under the right circumstances, it may be possible to divide the C corporation into two corporations, with the eligible shareholders owning the new corporation holding the real estate. Those shareholders then make the S election, hold the property for the requisite time period and sell it without double taxation, as in the example above. The requirements of this type of transaction are very strict and specific, however, and it should never be attempted without the contemporaneous advice of your tax professional.Consult your CBIZ MHM tax professional today to see what steps you can and should take now to get real estate out of your C corporation.
 Note that there are issues concerning the rental of real property to a closely-held related C corporation which are not covered in this article. Anyone contemplating such a transaction should thoroughly discuss it with your tax advisor prior to establishing the lease and the rental terms.
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