Sometimes in life, when faced with a given situation, we say things simply as a matter of reflex. For example:
“What an adorable baby!”
“You have a lovely home here.”
“You’re a great gal, I’ll call you sometime. Now can you help me find my pants?”
Things are no different in the tax world. As advisors, we keep an army of axioms always at the ready to be used in response to client queries. Take, for example, the client who contemplates the type of entity that should be used to hold a piece of real estate. For most tax practitioners, this would elicit the following Pavolovian reaction:
“You should NEVER put real estate inside a corporation.”
And while there are very few NEVERS in the tax world, this one is pretty darn accurate. But do you really understand why you should never put real estate into a corporation? It’s because, as the ensuing discussion will reflect, while real estate can go into a corporation tax-free, it can never come out tax free. In today’s Tax Geek Tuesday, let’s peel back the layers of the statute and find out why.
Case study: A, an individual, owns a building with a basis of $400,000 and a fair market value of $1,000,000. B, another individual, owns business assets worth $1,000,000. A and B would like to form a business that will use both the business assets owned by B and the building owned by A. The entity will be owned 50/50 by A and B. Should the entity be a C corporation, S corporation, or partnership?
Transfers to Controlled Corporations, In General
Under the general tax principles of Section 1001, the transfer of appreciated property triggers gain for the difference between the amount realized on the transfer less the adjusted tax basis of the property. Thus, barring a statutory exception, if A were to transfer the building to a corporation in exchange for the corporation’s stock, A would recognize $600,000 of gain ($1,000,000 fair market value less A’s $400,000 tax basis).
Section 351 is one such exception to the general rule of gain recognition, however, as it allows you to contribute appreciated property to a corporation in exchange for the corporation’s stock without recognizing gain provided you “control” the corporation immediately after the transfer.
For these purposes, “control” is defined as 80% of the vote and value of the corporation, with a couple of important distinctions. First, you don’t have to acquire 80% of the corporation; you simply must own 80% immediately after. A taxpayer who already owns say, 85% of a corporation may continue to transfer appreciated property to the corporation, and the gain will be deferred under Section 351.
In addition, Section 351 allows for a group of transferors. If you contribute appreciated property to a corporation in exchange for, say 20% of the corporation’s stock, but simultaneous to the transfer, another two individuals transfer cash or property to the corporation in exchange for an additional 65% of the stock, all three transfers are covered by Section 351 because on a combined basis, the transferor group controls the corporation immediately after the transfer.
Problems arise when the property contributed to a corporation is subject to a liability. Under Section 357(c), if you transfer property to a corporation that is subject to a liability and the corporation assumes that liability as part of the transfer, the transfer triggers gain to the extent the liability exceeds the tax basis of the property.
This provision is particularly problematic when the subject property is real estate, where mortgages are the norm. If, for example, A’s property were subject to a $700,000 mortgage, the transfer of the property to a corporation in exchange for corporate stock would generate $300,000 ($700,000 debt relief less $400,000 tax basis) of gain to A, even if the transfer were otherwise tax-free under Section 351.
Basis and Holding Period
When Section 351 applies to a transfer of property to a corporation, the gain is not excluded, it is merely deferred. This is accomplished through two statutory provisions that provide basis rules that ensure that any gain inherent in the building will be recognized if either you dispose of the corporation’s stock or the corporation disposes of the building.
Under Section 358, you must take a basis in the stock received equal to the basis in the property you transferred to the corporation. This is often referred to as a “substituted basis,” because the basis in the property received is determined in reference to the basis in the property relinquished.
In turn, Section 362 provides that the corporation must take a basis in the building equal to your basis in the building. This is often referred to as a “carryover basis,” because the corporation’s basis in the property remains unchanged from that which you held in the property.
Going back to our case study, if A and B simultaneously transfer property to a corporation in exchange for 50% of the corporation’s stock, Section 351 applies to the transfer. Despite the fact that A’s building has a fair market value of $1,000,000 and a tax basis of $400,000, no gain is recognized.
Under Section 358, A takes a basis of $400,000 in the corporate stock received. Because the total value of the corporation’s assets is $2,000,000, A’s 50% stock ownership is presumably worth $1,000,000. If A sells the stock for its value of $1,000,000, A will recognize $600,000 of gain, the amount that was deferred when A transferred the building to the corporation.
Under Section 362, the corporation takes a basis in the building of $400,000. If the corporation sells the building for its value of $1,000,000, the corporation will recognize the $600,000 of gain deferred on the contribution.
Distributions and Liquidations of C Corporations, In General
The big problem with placing real estate in a corporation does not present itself until it’s time to get the property out, whether as a sale or distribution.
As mentioned above, if the corporation sells the building, courtesy of the basis mechanics of Section 362, the sale will generate $600,000 of gain. This gain will be taxed at the corporate level at a maximum federal rate of 35%, resulting in $210,000 of corporate-level tax.
The tax inefficiency is only exacerbated if A would like to get his hands on the remaining $790,000 ($1,000,000 less $210,000 tax liability) of purchase price. If the corporation liquidates and distributes the net cash to A, A would be required by Section 331 to recognize capital gain for the difference between the amount distributed and A’s basis in the stock. A would recognize $390,000 of gain ($790,000 distribution less $400,000 stock basis) upon the liquidation, and assuming the stock were held longer than one year, would pay tax on the liquidation at a maximum rate of 23.8%, resulting in an individual tax bill of $93,000.
Thus, by selling the property in a C corporation and withdrawing the after-tax cash, A will incur a total tax liability in excess of $300,000.
Alternatively, A may simply have second thoughts about dropping the building into a corporation, and wish to unwind the transaction. If the corporation transfers the building to A in a non-liquidating distribution, Section 311(b) governs the taxability of the transfer. Under this provision, when a corporation distributes appreciated property to a shareholder, the corporation recognizes gain as if it had sold the property for its fair market value. Thus, the distribution would trigger $600,000 of gain to the corporation — just as it did with a sale — which would be taxed at a maximum federal rate of 35%.
And just as seen with a sale, A isn’t through paying tax yet. Under Section 301, A must treat the fair market value of the distributed property as dividend income (to the extent of any corporate E&P, which will include the $600,000 of gain) where it will be taxed at a maximum rate of 23.8%.
Things are equally painful if the corporation distributes the property to A in a liquidating distribution. Under Section 336, when a corporation transfers appreciated property in a liquidating distribution, the corporation recognizes gain as if the property were sold for its fair market value. Thus, the corporation would once again recognize gain of $600,000, just as it did in the sale and current distribution examples, and once again pay corporate level tax of $210,000.
Under Section 331, A is treated as having received payment for his corporate stock equal to the fair market value of the distributed property ($1,000,000) less the corporate tax liability assumed by A in the liquidation ($210,000). A receives $790,000 of payment in exchange for his stock with a $400,000 basis, resulting in long-term capital gain of $390,000 that is taxed at a maximum of 23.8%. As you may have noticed, these are the exact same tax consequences that would arise if the corporation had simply sold the building for cash and distributed the after-tax proceeds.
In summary, while A can get his building into the corporation without triggering the $600,000 of appreciation, he cannot get it out of the corporation — by sale or distribution — without incurring a tax liability of approximately $300,000. For this reason, a C corporation is not the ideal entity choice for A and his building.
Application to S Corporations
Section 351 applies equally to C and S corporations. Unfortunately, Sections 311(b) and 336 also apply equally to an S corporation. This means that if the S corporation distributes the property to A in either a non-liquidating or liquidating distribution, the S corporation will be treated as if it sold the property for its fair market value of $1,000,000, triggering $600,000 of corporate level gain.
Of course, S corporations – at least S corporations that are not subject to the built-in-gains tax (future Tax Geek Tuesday idea!) – do not generally pay tax at the corporate level. Instead, the $600,000 of gain will flow through to A who will pay tax on the income at the individual level, and the gain will increase his basis from $400,000 to $1,000,000 under Section 1367(a)(1). As a result, the distribution will not be taxed a second time at the shareholder level. If the distribution were of the non-liquidating variety, A would simply reduce his $1,000,000 stock basis by the $1,000,000 value of the building. If the property were distributed in a liquidating distribution, under Section 331 A would be treated as having received property worth $1,000,000 in exchange for stock with a basis of $1,000,000, resulting in no further gain or loss. .
Even with the favorable single-level taxation afforded S corporations, however, because of Section 331 A cannot take the property out of the corporation without incurring a tax bill of nearly $150,000 ($600,000 flow-through gain * 23.8% rate on LTCG or 25% rate on unrecaptured Section 1250 gain).
Application to Partnerships
So, what is it that makes partnerships such an attractive entity choice for holding real estate? For starters, just like corporations, appreciated property can be contributed to a partnership in exchange for a partnership interest without the recognition of gain. This is accomplished by virtue of Section 721, which works just like Section 351, only without as many restrictive rules.
For example, while Section 351 requires the transferor or a group of transferors to own more than 80% of the corporation immediately after the transfer in order to obtain tax-free treatment, Section 721 carries no such ownership requirement. Instead, an individual can transfer appreciated property to a partnership in exchange for as little as a 1% interest without triggering any gain.
Like Section 351, Section 721 is a deferral provision rather than an exclusion provision. Moreover, there are basis rules in Section 722 and 723 that mirror those previously discussed in Sections 358 and 362. Under these rules, when a partner transfers property to a partnership in exchange for an interest in the partnership, the partner takes a substituted basis in the partnership interest equal to his basis in the property contributed, and the partnership takes a carryover basis in the contributed property equal to the partner’s basis in the property.
Applying Section 721, 722 and 723 to our case study, A recognizes no gain on the transfer of property with a basis of $400,000 and a fair market value of $1,000,000 in exchange for a 50% interest in the partnership. A takes a basis of $400,000 in the partnership interest received, and the partnership takes a $400,000 basis in the real estate.
It is much less likely that transferring mortgaged property to a partnership will create gain, because there is no parallel to Section 357(c) in subchapter K. Instead, a transferor of mortgaged property to a partnership must apply the principles of Sections 731 and 752 to determine if gain is recognized on the transfer, and as shown below, gain can be avoided in the partnership context where it would be required in subchapter C.
Section 752 provides that a partner increases his basis in the partnership interest for his share of the partnership liabilities. Conversely, if a partner’s share of the partnership’s liability decreases, the reduction is treated as a distribution of cash to the partner. Why do we care?
Because Section 731 provides that a partner will only recognize gain on a distribution if the cash (or liability relief) distributed exceeds the partner’s basis in the partnership interest.
Combiningg these rules with the partner basis rules of Section 722, it becomes much less likely that a partner contributing leveraged property to a partnership will recognize gain.
To illustrate, assume the property A contributes to the partnership has a basis of $400,000, a fair market value of $1,700,000, and is subject to a $700,000 mortgage. If the property were transferred to a corporation, Section 357(c) would apply and A would be required to recognize $300,000 of gain on the transfer for the excess of the liability over the tax basis of the property.
The partnership rules yield a different result. Under Section 722, A takes an initial basis in the partnership interest of $400,000. Then, under Section 752, A increases his basis to reflect his 50% share of the $700,000 liability that now belongs to the partnership, or $350,000, raising A’s basis to $750,000. Finally, because A has been personally relieved of 100% of the liability upon transferring it to the partnership, this debt relief is treated as a distribution of cash to A by Section 752. Under Section 731, A must reduce his outside basis by the deemed distribution of $700,000. As a result, A’s final outside basis is $50,000 ($750,000 – $700,000).
Because the deemed distribution of $700,000 did not exceed A’s basis immediately before the distribution, no gain is recognized by A on the transfer.
Distributions and Liquidations of Partnerships, In General
While appreciated property can go into a corporation free from tax, as shown above, it can’t come out without the corporation being required to recognize gain as if the property were sold for its fair market value. Partnership law, however, provides deferral rules governing both the contribution of property to a partnership as well as the distribution of appreciated property from a partnership.
Sections 731 and 732 combine to provide that when a partnership distributes property to a partner in a current distribution, generally no gain or loss is recognized by either the partnership or the partner. Instead, the partner simply takes a basis in the distributed property equal to the lesser of:
- The partnership’s basis in the distributed property, or
- The partner’s outside basis in his partnership interest.
This nonrecognition treatment is extended to liquidating distributions as well. If a partnership transfers property to a partner in liquidation of the partnership, no gain is recognized by either the partnership or the partner; rather, the partner simply takes a basis in the property equal to the partner’s remaining basis in the partnership interest, after reduction for any cash received or debt relief.
And this is why partnerships are the vehicle of choice for holding real estate. Put a building in a C corporation, and it’s not getting out – either by sale or distribution – without triggering two levels of tax. Contribute the property to an S corporation instead, and the property can’t come out without triggering corporate-level gain. But place appreciated real estate into a partnership, and you receive the gift of flexibility; you can always undo your previous decision and distribute the building without recognizing gain at either the partnership or individual level.
Assume A and B transfer their respective properties to a partnership, and the value of the building increases from $1,000,000 to $2,000,000 while the tax basis of the building decreases from $400,000 to $300,000. Assume further that A’s basis in his partnership interest has also decreased from $400,000 to $250,000.
If the partnership distributes the building to A, neither A nor the partnership will recognize any gain on the distribution, despite the fact that the building’s fair market value of $2,000,000 greatly exceeds its tax basis of $300,000. Upon the distribution, A will take a basis in the building equal to the lesser of:
- The partnership’s basis in the building of $300,000, or
- A’s basis in his partnership interest of $250,000.
Thus, A reduces his basis in the partnership from $250,000 to zero and takes a $250,000 basis in the building.
If instead, the partnership liquidates and distributes the building to A in liquidation of his 50% interest, neither the partnership nor A will recognize gain. Instead, A will simply take a basis in the distributed building equal to A’s basis in the partnership interest, or $250,000.
Of course, these favorable distribution rules also operate on deferral principles; should A turn around and sell the property, the pre-distribution appreciation inherent in the building will be triggered by virtue or A’s modified carryover basis in the building. This still represents a tremendous advantage over the corporate regime, which forces the hand of the shareholder upon distribution by requiring the corporation to recognize all appreciation at the time of distribution. And that, above all other reasons, is why partnerships have become the entity of choice for holding real estate.
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