Software of the Month Club 1996 May/Software of the Month Club 1996 May.iso/mac/ISO9660/ZIPFILES/SBA962.ZIP/F115.SBE

Text File | 1996-02-15 | 7.4 KB | 153 lines

@103 CHAP ZZ

       ┌─────────────────────────────────────────────────┐
       │CHOICE OF ENTITY:   REAL ESTATE RENTAL BUSINESSES│
       └─────────────────────────────────────────────────┘

For many years, small businesses investing in income proper-
ty (real estate rental property) have tended to avoid the
corporate form, either using partnerships or holding such
real estate in sole proprietorships.  The main reasons for
this tendency were that:

    .  A C corporation cannot pass through tax losses to
       individual shareholders;

    .  Tax losses could be better utilized by the
       individual than a C corporation, since individual
       tax rates were generally higher;

    .  S corporations were not desirable for passing
       through losses, since deductible losses were lim-
       ited to the shareholders' basis for their stock
       (plus the basis of loans they made to the corpora-
       tion), whereas an individual or partner could
       count as part of his or her basis the mortgage on
       the real property;

    .  The limitations on "passive losses" for individuals
       did not exist until the Tax Reform Act of 1986; and

    .  Since 1982, S corporations have been subject to a
       corporate level tax on "excess net passive income"
       where passive income (including rents, no matter
       how "actively" the property is managed) exceeds
       25% of gross income.  (The special definition of
       "excess net passive income" for S corporations is
       unrelated to and not at all similar to the '86 Act
       definitions of passive activity income or loss
       that relate to virtually all types of taxpayers.)

In recent years, most of these ground rules have changed,
so that corporations, particularly S corporations, are now
much better candidates for holding real estate.  Since the
passive loss rules now either prohibit passive losses (ex-
cept to the extent of income from passive activities) or
limit losses from rental real estate to $25,000 a year for
an individual (phasing out for persons with adjusted gross
incomes between $100,000 and $150,000), the need for a lot
of "tax basis" to support huge real estate losses is much
less of a problem, so an S corporation may be quite suit-
able, even though cumulative losses are limited to a share-
holder's basis for his or her stock plus loans made to the
corporation by the shareholder.

Perhaps even more important, a C corporation (other than
a personal service corporation) is either not subject to
the passive loss limitations, or, in the case of a "closely-
held C corporation," can offset such losses against "net
active income" (but not against portfolio income such as
interest or dividends).  Thus, where large tax losses are
expected for a number of years, a C corporation may be able
to take such losses as deductions where another entity
could not.

However, a C corporation holding rental real estate still
has some major disadvantages.  One is that when the income
property becomes profitable, the profit will be taxed at
the corporate level and if the property appreciates in val-
ue, or even maintains a value beyond its (depreciated) tax
basis, there will ultimately be additional tax to pay, if
or when the corporation is liquidated someday in the future.
This additional tax would include any capital gain on the
stock held in the company at time of liquidation, plus cap-
ital gains on appreciated real estate in the corporation,
and ordinary income ("depreciation recapture") on deprecia-
tion deductions taken over a period of years by the company.
@IF167xx]As a company engaged in real estate rental operations, you
@IF167xx]could find yourself in a very serious tax trap someday if
@IF167xx]@NAME were to become a C corporation.
@IF167xx]
@IF167xx]Fortunately, this does not now appear to be a problem for
@IF167xx]@NAME, currently a @ENTITY.

Another disadvantage of operating as a C corporation is
that the rental income may be considered "personal holding
company" income, subject to a 39.6% penalty tax if not distri-
buted, if the company has significant amounts of other
"personal holding company income" of other types, such as
dividends and interest.  (If 50% or more of a company's
"adjusted ordinary gross income" is considered "adjusted
income from rents," the rental income itself won't cause a
problem, but even in that case it must distribute any other
kinds of personal holding company income, such as interest
or dividends, that exceed 10% of "ordinary gross income.")
@IF166xx](This, however, will not be a consideration in the case of
@IF166xx]your business -- although yours is a C corporation, it will
@IF166xx]not be considered a "personal holding company," since you
@IF166xx]have indicated that no 5 individuals control over 50% of the
@IF166xx]stock of @NAME.)

Thus, on balance, it is now hard to make any blanket state-
ment as to which type of entity is best for holding rental
real estate.  Using a corporation should no longer be ruled
out under present law, especially an S corporation that
elects S status in its first tax year and thus is exempt
from the special tax on "excessive passive income."  Hold-
ing real property in a corporation may now make very good
sense, depending upon your particular situation.  This is
a very complex decision that, in most cases, should be made
only after consulting a competent tax accountant or tax
attorney, however.
@IF118xx]
@IF118xx]PLANNING POINT FOR @NAME:
@IF118xx]┌─────────────────────────────────────────────────────────────┐
@IF118xx]│As an S corporation, be sure that if the corporation has pas-│
@IF118xx]│sive income, such as dividends, interest, rents or royalties,│
@IF118xx]│that you obtain competent tax advice as to whether or not    │
@IF118xx]│the special tax on "excessive passive income" is applicable  │
@IF118xx]│to your company.  You may be exempt from it, but....         │
@IF118xx]│                                                             │
@IF118xx]│The tax consequences of not knowing could be most unpleasant.│
@IF118xx]└─────────────────────────────────────────────────────────────┘

On balance, the author of this program is of the view that
keeping real estate out of a C corporation will continue to
be advisable in most situations, but that holding rental
property in an S corporations is now virtually on a par with
holding it individually or in a partnership, at least in the
case of a new S corporation that is not subject to the spe-
cial S corporation tax on "excessive net passive income."

Even more attractive for holding rental real estate, in
many cases, is the "limited liability company" (LLC) entity,
which offers partnership pass-through tax treatment, coupled
with the limited liability benefits of a corporation.

@CODE: HI MA VT
However, LLCs cannot be established yet under the laws of
@STATE, one of the few states that don't allow LLCs.

@CODE:OF

     ┌──────────────────────────────────────────────────────┐
     │BOTTOM LINE RECOMMENDATION:   UNDER  CURRENT TAX LAWS,│
     │INCORPORATING RENTAL REAL ESTATE COULD NOW MAKE SENSE,│
     │ALTHOUGH THIS WAS RARELY TRUE BEFORE THE 1986 ACT.  IN│
     │PARTICULAR, S CORPORATIONS ARE NOW FREQUENTLY A VIABLE│
     │CHOICE  FOR HOLDING  RENTAL PROPERTIES.   BUT  CONSULT│
     │YOUR TAX ADVISER BEFORE INCORPORATING YOUR PROPERTIES!│
     └──────────────────────────────────────────────────────┘