Tax Considerations For Entity Choice With Real Property
Real estate investors frequently come to me seeking advice regarding placing their investments into business entities for asset protection and other business reasons. Almost always, the LLC is the entity of choice for real estate investments. The reasons behind this simplistic answer, however, are far more complex.
Under the Section 1001 of Tax Code, the “sale or other disposition” of property triggers the computation of gain or loss. This “sale or other disposition” is commonly referred to as a realization event. If Harry, owner of real property with a tax basis of $500, sells that real property to Sally for $750, Harry incurs tax liability for his $250 gain arising out of that sale.
Transferring Property to LLCs and Corporations
One consideration relating to Section 1001 is whether a transfer of real property to a corporation or an LLC amounts to a realization event for purposes of computing loss or gain. The answer depends on the entity and the particular circumstances of the parties involved in the transfer.
Generally, when property is transferred to an LLC in exchange for an interest in that LLC, the Tax Code provides that “[n]o gain or loss shall be recognized.” 26 USC § 721(a). As such, (in keeping with our last example) when Harry transfers real property to his LLC in exchange for an interest in that LLC, Harry does not incur tax liability for the $250 gain. Instead, the Tax Code and associated regulations provide that the tax liability arising out of Harry’s gain will accrue when the LLC sells the real property. (The allocation of the tax liability arising out of this “built-in gain” will be the subject of next week’s post.)
The Tax Code also provides for the nonrecognition of gain for transfers of real property to corporations in exchange for stock, but only under certain conditions. Specifically, the corporation receiving the property must be within the “control” of the transferor. 26 USC § 351(a). The Code defines control as “possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.” 26 USC § 368(c). In other words, if Harry transfers real estate to B Corp. in exchange for 50% of B Corp.’s stock, then such a transfer falls outside the scope of the Section 351 exception and the transfer will be considered a realization event. As a result, Harry will incur tax liability on any gain in the transfer to the corporation.
Property transfers to corporations are further complicated by properties encumbered by mortgages (or other liabilities). Even if property is transferred to a corporation pursuant to Section 351 for purposes of avoiding a realization event, the existence of a mortgage on the property may impose tax liability on the transferor. If a property is transferred to a corporation (subject to Section 351) and the corporation assumes liabilities that exceed the total adjusted basis of the transferred property, then “such excess shall be considered as gain from the sale … of property.” 26 USC § 357(c)(1).
This brief discussion of the tax consequences of transferring property into LLCs and corporations is not exhaustive, particularly as it pertains to corporations. There are numerous additional considerations for individuals placing property into a corporation that are entirely dependent on the circumstances unique to every individual. Contrarily, the tax regulations promulgated against the transfer of property to LLCs are significantly more straightforward with less opportunity for “tax pitfalls.” This conversation highlights once again the vast legal differences between LLCs and corporations, and the need for professionals to understand and respect those differences. Remember, LLCs are not corporations.