Cream of the Crop 1/Cream of the Crop 1.iso/BUSINESS/SBA62.ARJ/FSBA.EXE/F115.SBE

Text File | 1992-04-30 | 6KB | 105 lines

@103 CHAP ZZ

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          │CHOICE OF ENTITY:   REAL ESTATE RENTAL BUSINESSES│
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For many years, small businesses investing in income property (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 limited
          to the shareholders' basis for their stock (plus the
          basis of loans they made to the corporation), 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 candi-
dates for holding real estate.  Since the passive loss rules now
either prohibit passive losses (except 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 suitable, even though cumulative
losses are limited to a shareholder's basis for his or her stock plus
loans made to the corporation by the shareholder.

Perhaps even more important, maximum corporate tax rates are now higher
than individual rates, so that where losses will be generated, the
losses may be more beneficial if used by a C corporation.  Also, 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 corp-
oration may not only be able to take such losses as deductions where
another entity could not, but will also be using those losses at higher
tax brackets, thus getting "more bang for the buck" for any usable tax
losses.

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 higher corporate rates and if
the property appreciates in value beyond its (depreciated) tax basis,
there will ultimately be a second tax to pay, if or when the corpora-
tion is liquidated.  Another disadvantage is that the rental income
may be considered "personal holding company" income, subject to a 28%
penalty tax if not distributed, if the company has significant amounts
of "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 "adjusted income from rents", the rental income itself will
not be a problem, but 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.")

Thus, on balance, it is now hard to make any blanket statement 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."  Holding
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.

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 partner-
ship, at least in the case of a new S corporation that is not subject
to the tax on "excessive net passive income."

        ┌──────────────────────────────────────────────────────┐
        │BOTTOM LINE RECOMMENDATION:   UNDER  THE NEW 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!│
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