Real estate can be an attractive long-term business investment. For tax reasons, you’re generally well-advised not to hold real property in a corporation. Here’s why limited liability companies (LLCs) and revocable trusts are usually better alternatives.
To illustrate the effects of double corporate taxation, suppose your solely owned C corporation business needs a building. First, let’s assume you set up a single-member limited liability company (SMLLC) owned solely by you or a revocable trust to buy the property and lease it back to the corporation. After a few years, you sell the property for a $500,000 gain. What’s the appropriate tax treatment?
In this scenario, the entire gain will be taxed on your personal return. Part of the gain will be taxed at 25% (the amount of gain attributable to depreciation deductions). The remaining gain will currently be taxed at no more than 20%. You may also owe the 3.8% net investment income tax (NIIT) and state income tax on all or part of the gain.
Let’s say you pay a total of $130,000 to Uncle Sam for capital gains tax and the NIIT. There’s no federal income tax at the SMLLC level, so the after-tax profit is $370,000 ($500,000 minus $130,000). For purposes of this example, we’ll ignore state income tax.
How would the tax outcome differ if your C corporation bought the same property? The $500,000 gain will be taxed at the 21% corporate rate. The corporation will pay the $105,000 federal income tax bill ($500,000 times 21%) and distribute the remaining $395,000 to you ($500,000 minus $105,000). (Again, we’ll ignore any corporate state income tax.)
Let’s assume the $395,000 constitutes a dividend that will be taxed at the maximum 20% individual rate. Plus, we’ll assume you owe the 3.8% NIIT on the $395,000 gain. So, the federal income tax hit at your personal level is $94,010 ($395,000 times 23.8%). After paying federal income taxes at both the corporate and personal levels, you’ll end up with only $300,990 after taxes ($500,000 minus $105,000 and $94,010). That’s $69,010 less ($300,990 vs. $370,000) than you’d receive under the SMLLC/revocable trust ownership alternative.
Important: Your personal tax bill would be a bit higher under the SMLLC/revocable trust ownership alternative due to the 25% federal rate on gains attributable to depreciation. Depreciation lowers the tax basis of the property, so a tax gain results whenever the sale price exceeds the depreciated basis.
Double Taxation Threat
Holding depreciable real property or land in a C corporation is generally a bad idea from a tax perspective. If you sell the property for a taxable gain (net sales proceeds in excess of the tax basis of the property), the gain could be taxed at both:
- The corporate level, and
- The individual shareholder level when the gain is distributed as all or part of a dividend.
However, double taxation isn’t as adverse as it was before the Tax Cuts and Jobs Act (TCJA). Why? The TCJA permanently installed a flat 21% corporate federal income tax rate. This rate applies to all corporate taxable income, including gains from selling real estate. In addition, there are still favorable 15% and 20% federal income tax rates for corporate dividends received by individuals. Be advised that individuals might also owe the 3.8% net investment income tax (NIIT) on dividends as well as state income tax at the personal level.
Before the TCJA, the maximum effective corporate federal income tax rate was 35% instead of the current 21%. And before 2003, dividends received by individuals were taxed at higher ordinary income rates. On the personal side, ordinary income rates could reach 39.6% before the TCJA, compared to the current 37% maximum rate.
While the threat of double taxation is diminished under current tax law, in the future, Congress could potentially increase the corporate tax rate, revert to taxing dividends at ordinary income tax rates and/or increase the maximum individual rate on ordinary income. If these changes happen, double taxation could once again become a major downside to operating as a C corporation.
You can have a taxable gain when you sell depreciable real property even if the value of the property hasn’t increased. That’s because depreciation deductions reduce the tax basis of the property. So, if your C corporation sells depreciable property for exactly what it cost, there will be a taxable gain equal to the cumulative depreciation deductions claimed over the years. That gain could potentially be hit with double taxation.
Important: Using an S corporation to develop raw land and sell off parcels can save significant tax in the right circumstances, thanks to special federal income tax rules that can potentially apply in this scenario. Contact your tax advisor to learn the details.
Another option is a single-member LLC (SMLLC), which has only one owner (called the “member”). You generally ignore the existence of an SMLLC for federal tax purposes under IRS “check-the-box” entity classification regulations. The exceptions are:
- When you elect to treat the SMLLC as a corporation for tax purposes (relatively unusual), and
- When for purposes of federal employment taxes and certain federal excise taxes, the SMLLC is treated as a corporation.
When you choose to not treat your SMLLC as a corporation for federal income tax purposes, the SMLLC has so-called “disregarded entity” status. The federal income tax treatment of a disregarded SMLLC is simple — its activities are considered to be conducted directly by the SMLLC’s sole member. So, when you use a disregarded SMLLC that’s owned by you to own real estate, you simply report the federal income tax results, including any gain on sale, on your personal tax return. You aren’t required to file a separate federal income tax return for the SMLLC.
Although a disregarded SMLLC is ignored for federal income tax purposes, it isn’t ignored for state law purposes. Therefore, a disregarded SMLLC will deliver to its sole member the liability protection benefits specified by the applicable state LLC statute. These liability protection benefits are usually similar to those offered by a corporation. So SMLLC ownership offers the best of both worlds: favorable tax treatment and limited legal liability.
Revocable Trust Option
If real property will be owned solely by you (or only you and your spouse), consider using a revocable trust to hold the property. Revocable trusts are also commonly called grantor trusts, living trusts or family trusts.
Because you can terminate a revocable trust at any time, any property owned by the trust is considered to be owned for federal tax purposes by the grantor(s) of the trust. The grantor is the individual or spouses who established the trust.
So if you use a revocable trust to own real estate, you simply report the federal income tax results, including any gain on sale, on your personal tax return. You aren’t required to file a separate federal tax return for the trust, and there’s no risk of double taxation.
If you and your spouse set up a revocable trust, it will typically continue to exist after the first spouse dies. So the surviving spouse’s tax returns will be prepared without regard to the trust.
The advantage of holding property in a revocable trust is that probate is avoided when you die. The property will go directly to the beneficiary or beneficiaries of the trust and/or the surviving spouse, if applicable. In contrast, if you own property directly without a revocable trust, the probate process can be expensive and time consuming. Consult with your attorney if you’re interested in learning more.
For More Information
C corporations are subject to double taxation, so they generally shouldn’t be used to own real property. Instead, SMLLCs and revocable trusts may be better alternatives from a tax perspective. Consult an attorney about legal plusses and minuses of using these entities. Your tax advisor can help you work through the federal and state tax issues.