Real Estate for My Business:
By Carl Vulcan, CPA, CFE
Just like people, every business needs a place to call home. However, unlike an individual’s home, differences in the tax structure of the business’s home can greatly affect the tax bill on the sale or operations of that business real estate.
In most cases, particularly when the business is closely-held, or a family business, it is advisable to separate the ownership of the real estate from the operating business entity. For example, if an operating business is a corporation where a single individual is the only stockholder, the ownership of the real estate used by the business should be split out into a separate entity.
The primary reason is that “C Corporations”, those that are separate tax paying entities, do not qualify for capital gains tax rates, as do pass-through entities, such as partnerships, “S Corporations” or single member Limited Liability Companies. Pass-through entities allocate ordinary and capital gain taxable income to their partners, or shareholders, who are generally, individuals. Individuals are taxed at graduated rates up to 37 percent on ordinary taxable income, however, capital gains are taxed at the individual level at 20 to 25 percent.
The business operations entity may set up a lease agreement with the real estate owning entity with a rent payment adequate to cover the cash flow requirements of the rental operation. A common structure used is when a business owner who opts to include a spouse as a partner in a real estate owning partnership that leases to the owner’s business operations company. Often a family partnership is formed and children of the owner can be included in the ownership of the real estate partnership, producing an income source to them as a tax planning strategy. This strategy may also be used to reduce Net Investment Income taxes for individual taxpayers in the upper income brackets.
Another advantage of separate entity ownership is that the business operations are not tied to the real estate. The business may outgrow the physical limitations of the existing real estate. A business decision may be made to relocate the business operations into a more efficient, or larger facility. The existing real estate may be sold or leased to a third party. In these circumstances, the tax impact of the lease or sale does not affect the tax position of the operating business and the real estate owner report the gain or loss on sale or rental operations on their separate tax return. As a pass through entity, the tax rate on a gain on sale of the facility to the real estate entity is passed through to the individuals owning it at the more favorable personal capital gain rates.
The owners of the real estate may choose to continue the operation of the facility under a lease arrangement with an outside party. Again, the separate real estate tax entity provides the flexibility to possibly operate the rental property with tax advantages, or consequences, passed through to the individuals owning the interests in the real estate entity.
As with any tax strategy, the facts and circumstances of the individual’s tax structure are to be considered carefully and consultation with a tax professional is advisable and recommended.