Be sure to start with Part I, here!
Real Estate as an Active Business
The active conduct of a trade or business does not include the holding for investment purposes of land, or other property, or the ownership and operation (including the leasing) of real property used in a trade or business, unless the owner performs significant services with respect to the operation and management of the real property.
In addition, a rental activity will not satisfy the active trade or business requirement if it is merely incidental to another business. Indeed, separations of real property, all or substantially all of which is occupied prior to the distribution by the distributing or the controlled corporation, will be carefully scrutinized with respect to this requirement.
The following illustrations are from actual IRS rulings regarding the application of the active trade or business requirement with respect to rental real estate.
- A corporation did not engage in “entrepreneurial endeavors of such a nature and to such an extent as to qualitatively distinguish its operations from mere investments” where the corporation employed no individuals and virtually all of the real estate was leased to a related entity.
- Corporation X owns, manages, and derives rental income from an office building and also owns vacant land. X transfers the land to new subsidiary Y and distributes the stock of Y to X’s shareholders. Y will subdivide the land, install streets and utilities, and sell the developed lots to various homebuilders. Y does not satisfy the requirements for a tax-free spin-off because no significant development activities were conducted with respect to the land during the five-year period ending on the date of the distribution.
- For the past seven years, corporation X has owned an eleven-story office building, the ground floor of which X has occupied in the conduct of its business. The remaining ten floors are rented to various tenants. Throughout this seven-year period, the building has been managed and maintained by employees of the corporation. Inasmuch as the rental activities are substantial and require direction by a separate real estate department, the rental activity constitutes an active trade or business. X transfers the building to new subsidiary Y and distributes the stock of Y to X’s shareholders. Henceforth, Y will manage the building, negotiate leases, seek new tenants, and repair and maintain the building. X and Y both satisfy the requirements for a tax-free spin-off .
- For the past nine years, corporation X, a bank, has owned a two-story building, the ground floor and one half of the second floor of which X has occupied in the conduct of its banking business. The other half of the second floor has been rented as storage space to a neighboring retail merchant. This rental activity was only incidental to the banking business. X transfers the building to new subsidiary Y and distributes the stock of Y to X’s shareholders. After the distribution, X leases from Y the space in the building that it formerly occupied. Under the lease, X will repair and maintain its portion of the building and pay property taxes and insurance. Y does not satisfy the requirements for a tax-free spin-off because it is not engaged in the active conduct of a trade or business immediately after the distribution.
- Prior to a spin-off, a corporation was engaged in the active trade or business of renting its commercial and residential real estate to unrelated third parties even where all operational activities in connection with the rental business were performed by employees of its sister company. The corporation’s officers – who were also officers of the sister company – supervised, controlled and directed the employees of the sister company who performing the work. The corporation reimbursed its sister company for these services. Through these officers and the employees of the sister company the corporation was able to demonstrate that, among other things, it: negotiated the purchase of, and the required financing for, properties; renovated the properties; periodically refurbished the properties; endeavored to keep the properties rented; provided and paid for gas, water, electricity, sewage, and insurance for the property; paid the taxes assessed on the property; provided day-to-day maintenance and repair services; performed routine inspections of the properties; and maintained separate records and accounts to reflect the income and expenses relating to each rental property.
- A corporation that owned an office building was not engaged in an active rental business where an unrelated real estate management company, acting as an independent contractor, was under contract to manage the building. The management company: supplied and supervised janitors and , maintenance personnel; arranged for all repairs to be made by independent contractors; collected rents, paid all bills, advertised for tenants; negotiated the terms of leases; and fielded and handled tenant complaints. The corporation’s activities were not different from those a prudent investor would be expected to undertake. The operational and management activity of the office building was largely performed by the management company and the independent contractors hired by the management company.
What if a corporation does not currently satisfy the active trade or business requirement with respect to any of its properties?
All is not lost – the are options to consider, some of which are described below, but one has to be patient. Moreover, one must not lose sight of business exigencies or of the goal sought to be accomplished. Tax-free is nice, but probably not at the expense of a bad choice from a business perspective.
First, the corporation can change how it operates by hiring one or more employees to perform significant managerial and operational functions. This will represent a change to an active business that will have to be conducted for at least five years. Query how practical this is given the circumstances that are compelling the division of the shareholders.
Second, if the corporation plans to sell any of its non-actively-managed properties as part of a like-kind exchange, it may look for replacement properties that will require active management.
Third, the corporation can acquire new properties that will require active management. Again, the five-year period would have to pass.
Finally, the corporation may invest in one or more partnerships that are actively engaged in a rental business. Provided it acquires a not insignificant interest in the partnership(s), and holds its interest for at least five years, the corporation may satisfy the active trade or business requirement.
There are other facts and circumstances – such as a basis step-up at the death of shareholder – that may facilitate a split-off of corporate property even through what would otherwise be a taxable transaction. It may also be possible to compensate the corporation or the shareholders for the resulting tax liabilities by adjusting the exchange consideration with cash.
Of course, the best option of all would be not to acquire real property in a corporation.