A Basic Principle
Do you remember the scene from “History of the World Part I” when Mel Brooks, in the role of Moses, calls out “Hear me, oh hear me! All pay heed! The Lord, the Lord Jehovah has given unto you these fifteen [he drops one of the three tablets cradled in his arms and it shatters] – oy – these ten, Ten Commandments for all to obey.”[i]
Scholars have long debated what the five lost commandments may have been. I have my own hunch, at least as to one of them: “Thou shall not acquire and hold real property in a corporation, or in any business entity that has elected to be treated as an association.”[ii]
I have deduced that this must be the case from the number of inquiries I receive on a regular basis regarding the disposition of real property owned by a closely held corporation. One cannot easily explain away this state of affairs. How else might one account for any transgression of this basic principle? The only logical conclusion, I have determined, is that the public must be unaware of this missing commandment.[iii] Makes sense, right?
After all, how would one knowingly deny oneself the ability to increase the adjusted basis[iv] for their interest in a real estate partnership by their share of the indebtedness incurred by such partnership, even when the indebtedness is nonrecourse? This principle – which no doubt would have inspired realms of commentary and annotations to the missing commandment – enables a partner in such a partnership to claim their share of depreciation deductions attributable to such indebtedness[v]; it also supports a partner’s ability to withdraw their share of any loan proceeds from the partnership without incurring any tax.[vi]
There is no comparable basis adjustment rule for the shareholder of a corporation, including a pass-through entity such as an S corporation.[vii]
Regardless of how we got here, well, here we are. “Do what you can, with what you have, where you are,” as Teddy Roosevelt said.
With TR’s guidance in mind, let’s consider a question that was put to me just a few days ago.
We Want To Split Up
Corporation’s principal asset is a mixed use[viii] apartment building. Thanks to the appreciation in its value over the years, plus the cost-recovery deductions[ix] claimed by the corporation, there is substantial gain inherent in the real property.[x] The corporation would realize this gain if the corporation were to dispose of the building in a taxable transaction.[xi]
Corporation has two individual shareholders (“S/H One” and “S/H Two”) who are not related to one another. For years, they have both been active in the management and operation of the building.
For various reasons, the two shareholders no longer get along, and would like to separate from one another. They would like to do so, however, on as tax-efficient a basis as possible – meaning, they’d like to avoid taxable gain at both the corporate and shareholder levels. Ideally, each of them would also continue to be invested in real property.
Not too much to ask for, right?[xii]
Let’s begin by assuming that S/H Two will be the departing shareholder, and that S/H One is not interested in replacing S/H Two with another shareholder. There are some options to consider.
Of course, S/H One may purchase all of S/H Two’s shares of Corporation stock. Alternatively, Corporation may redeem all of S/H Two’s shares.[xiii] Finally, S/H One and Corporation may join in buying out S/H Two.[xiv]
In each of these cases, the consideration for the purchase of S/H Two’s shares may be some combination of cash and a promissory note. It is likely that the funding source for such cash, and the collateral for such note, will be Corporation’s equity in the real property.[xv]
At the end of the day, S/H One ends up owning 100-percent of Corporation and, indirectly, the underlying real property, while S/H Two’s interest in Corporation is terminated by way of a sale of their stock.
Unfortunately for S/H Two, the gain from such a sale will be taxable to them.[xvi]
If S/H Two was still interested in holding real property, they may use the after-tax proceeds (and perhaps some debt) to acquire other real property.
Like Kind Exchange?
S/H Two is not especially keen on recognizing gain in connection with the buyout of their shares of stock in the Corporation.
They wonder whether they could “reinvest” their equity in other real property as part of a like kind exchange.[xvii] Having heard about partnership “drop and swap” transactions from various business acquaintances, S/H Two asks whether this approach is feasible in their case.
Unfortunately for S/H Two, the proceeds from the sale of their Corporation stock may not be reinvested as part of a tax-deferred like kind exchange, notwithstanding that Corporation’s only asset was real property.
Moreover, the drop-and-swap technique is not available in the case of real property that is owned by a corporation, even if the corporation is a pass-through entity, like an S corporation. To understand why, let’s first review the like kind exchange rules.
An exchange of property, like a sale, generally is a taxable event, and the gain therefrom is included in the exchanging taxpayer’s gross income for purposes of determining their income tax liability.
However, no gain or loss will be recognized if real property held by a taxpayer for productive use in a trade or business or for investment is exchanged for real property of a ‘‘like kind’’ which is to be held for productive use in a trade or business or for investment.[xviii] In general, this non-recognition rule does not apply to any exchange of real property that, in the hands of the taxpayer, is held primarily for sale.[xix]
The determination of whether real property is of a ‘‘like kind’’ to other real property relates to the nature or character of the property and not its grade or quality; for example, improved real estate and unimproved real estate generally are considered to be property of a ‘‘like kind’’ as this distinction relates to the grade or quality of the real estate.[xx]
The non-recognition of gain in a like kind exchange applies only to the extent that like kind property is received in the exchange. Thus, if an exchange of real property would meet the requirements for non-recognition, but for the fact that the property received in the transaction consists not only of real property that would be permitted to be exchanged on a tax-free basis, but also of non-qualifying property[xxi] or money[xxii] (“boot”), then the recipient of such boot will be required to recognize their gain realized on the exchange; however, the amount of gain recognized may not exceed the fair market value of such boot.[xxiii]
Although a partnership is a pass-through entity – meaning that its items of income, gain, deduction and loss flow through to its partners, and are included by them, in determining their respective taxable income[xxiv] – the like kind exchange rules are applied at the level of the partnership.[xxv]
In general, a partnership[xxvi] may utilize a “drop-and-swap” in a situation where some of its partners want to dispose of the partnership’s real property as part of a like kind exchange in which the partnership would acquire other real property,[xxvii] while other partners want to cash out their investment. The drop-and-swap affords both sets of partners the opportunity to satisfy their respective goals.[xxviii]
For example, the partnership may distribute tenancy-in-common (“TIC”) interests in the real property to those of its partners who want to cash out of the partnership; these partners would sell their TIC interests to the buyer for cash; meanwhile, the partnership would exchange its TIC interest for like kind property as part of a tax-deferred exchange.
The key to this technique is the ability of a partnership to distribute property in-kind[xxix] (for example, real property) to its partners without triggering recognition of the gain inherent in such property, and without causing the partners to include the distribution in their gross income.[xxx]
Corp’s In-Kind Distribution
Is this approach available to a corporation? Not really.
If a corporation were to distribute an appreciated property, or a portion thereof (a TIC interest), to some of its shareholders in exchange for their shares in the corporation (a redemption), the corporation would be treated as having sold the distributed property for consideration equal to the fair market value of such property.[xxxi] In the case of a C corporation, or of an S corporation that was subject to the built-in gain tax,[xxxii] the distribution/deemed-sale would generate gain subject to corporate-level tax. In the case of an S corporation, all of its shareholders – including those whose shares were not redeemed – would recognize the gain from the distribution[xxxiii]; depending upon whether or not the “related party sale” rules apply, such gain may be treated as ordinary income in the hands of the shareholder.[xxxiv]
What’s more, the fair market value of the property distributed would be taxable to the recipient shareholder to the extent it exceeds the shareholder’s adjusted basis for their stock.[xxxv]
In other words, a drop-and-swap-like strategy does not work where the real property is owned by a corporation.
Get Me Out of Here
Are there other alternatives? Maybe.
If Corporation’s rental business qualifies as an “active trade or business” within the meaning of the so-called “spin-off” rules,[xxxvi] and if Corporation has at least two rental properties, it may be possible for Corporation to contribute one of the properties to a subsidiary corporation and to then distribute the stock of the subsidiary corporation to S/H Two in redemption of all of the Corporation stock owned by S/H Two. Provided certain other requirements are satisfied, the distribution may be effected on a tax-deferred basis.[xxxvii]
But wait, you may say, Corporation has only one property. That’s true, but what is to prevent Corporation from acquiring a second property by purchase, or by replacing its one real property with two real properties as part of a like kind exchange,[xxxviii] with both properties continuing to be used in an active rental real estate business?[xxxix]
In order for a “split-off” (basically, a separation of shareholders into different corporations) to qualify as a tax-deferred transaction, each of the distributing corporation and the distributed subsidiary corporation must be engaged in the active conduct of a trade or business immediately after the distribution. The trade or business that is relied upon to satisfy this requirement is one that has been actively conducted throughout the five-year period ending on the date of the distribution.[xl]
Significantly, according to the IRS, the fact that a trade or business underwent change during the five-year period preceding the distribution will be disregarded for purposes of the active business test, provided that the changes were not of such a character as to constitute the acquisition of a new or different business.
In particular, if a corporation that is engaged in the active conduct of one trade or business during that five-year period purchases or otherwise acquires another trade or business in the same line of business, then the acquisition of that other business will ordinarily be treated as an expansion of the original business, all of which is treated as having been actively conducted during that five-year period, unless that purchase or other acquisition effected a change of such a character as to constitute the acquisition of a new or different business.[xli]
Thus, if Corporation is able to acquire a second rental real property which is operated as actively as the existing property, Corporation should be able to satisfy the active business test.
It should follow, based on the foregoing, that a corporation which has been actively engaged in a rental real estate business should be able to exchange its existing property for one or more new real properties, as part of a tax-deferred like kind exchange, without jeopardizing its satisfaction of the active business test, at least where the replacement properties are used in the same manner as the relinquished property.
In fact, about four years ago, we submitted a ruling request to the IRS on behalf of a corporate client engaged in an active rental real estate business. Between three and four years earlier, the corporation had disposed of its principal property and acquired several replacement properties during the replacement period as part of a like kind exchange.[xlii] For bona fide business reasons,[xliii] the corporation’s shareholders subsequently sought to go their own ways by dividing the real properties between two corporations. The IRS ruled that the acquisition of the replacement properties during the five-year period preceding the distribution constituted an expansion of the corporation’s business, and did not represent the acquisition of a new or different business.[xliv]
All’s Well That Ends Well?
Ugh, another idiom,[xlv] and perhaps the wrong one at that, under the circumstances. Although it may be that Corporation and S/H Two have found a path that may lead them to the tax-deferred separation of S/H Two from Corporation and S/H One, it is still the case that both shareholders will continue to hold their respective real property in corporate form, with all the impediments that it entails.
Does that mean the shareholders should accept their lot? Nope.
Although there are many factors to consider – several of which are in a state of flux this election year, including, for instance, the future of the 21-percent corporate tax rate – the shareholders should not be dissuaded from mapping out a plan for ameliorating the consequences of corporate ownership.
For one thing, they may want to ask their tax advisors about making an election to treat their corporation as an S corporation for tax purposes.[xlvi] Although this may not represent much of a difference in overall tax liability for a corporation that regularly distributes its profits to its shareholders as a dividend, at least under current rates,[xlvii] it will position a shareholder to save significant tax dollars on a later sale of their corporation’s property.[xlviii]
They may also want to consider having the corporation contribute the real property to an LLC in exchange for a preferred interest[xlix] – so as to “freeze” the corporation’s value – while the shareholders make their own capital contribution to the LLC in exchange for the common interests, which would be entitled to the future appreciation of the property.
That, however, is a topic for another day.
[i] If you haven’t see this movie, do yourself a favor. OK? You’ll understand why Mr. Brooks has been awarded an Oscar, a Tony, an Emmy and a Grammy. “Young Frankenstein” and “Blazing Saddles” are two of my favorites.
[ii] Of course, this should be read less as a law and more like a guiding principle to which there may be exceptions under certain facts and circumstances. For example, a foreign corporation may be the right choice of entity for a nonresident alien thinking about acquiring an interest in U.S. real property, especially given the current corporate tax rate. That being said, the November elections are just around the corner. Mr. Biden has proposed increasing the corporate rate from 21% to 28%.
[iii] In case you’re wondering, yes, most of these corporations acquired their real property before the advent of the LLC (though there are exceptions). Query, however, why these folks didn’t use a limited partnership with a corporation (perhaps an S corporation) as the general partner?
[iv] A measure of their “unrecovered investment” in the partnership. Yes, that includes the partner’s share of partnership indebtedness. See IRC Sec. 752(a), which treats any increase in a partner’s share of partnership liabilities as a contribution of money by the partner to the partnership. Same as if the individual partners had borrowed the funds themselves to acquire the property – an example of the aggregate theory of partnership taxation. See also Reg. Sec. 1.752-2 and Sec. 1.752-3.
[v] Remember, a partner’s distributive share of partnership deductions/loss is allowed only to the extent of the adjusted basis of the partner’s interest in the partnership. IRC Sec. 704(d).
See also IRC Sec. 465(b)(6), which tells us that a taxpayer may be considered at risk with respect to their share of “qualified nonrecourse financing” incurred in the activity of holding real property.
[vi] A distribution of cash by a partnership to a partner will be taxable to the partner only to the extent it exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution. IRC Sec. 731(a)(1).
[vii] In other words, the shareholder of an S corporation does not increase the basis for their stock by their “share” of the corporation’s indebtedness.
That being said, there are some S corporation rules that have counterparts in the partnership rules; for example, a shareholder cannot claim deductions in excess of the adjusted basis for their shares, and a shareholder may – generally speaking – receive distributions from the corporation without triggering a taxable event to the extent of such adjusted basis. IRC Sec. 1366(d) and Sec. 1368.
[viii] Residential and professional/commercial.
[ix] Depreciation. IRC Sec. 167 and Sec. 168.
[x] IRC Sec. 1001. Part of this gain is attributable to the depreciation deductions claimed by the corporation. This gain is treated as so-called “unrecaptured” depreciation which, in the case of an individual taxpayer (a direct owner, or an equity owner of a partnership or S corporation) would be taxed at the rate of 25%. The gain attributable to the appreciation in value over the original cost of the property is treated as capital gain, which would be taxable at 20% in the case of an individual with a direct or indirect interest in the real property. IRC Sec. 1(h). The 3.8% surtax on net investment income may also apply if the individual did not materially participate in the business. IRC Sec. 1411.
[xi] If the corporation were a C corporation, it would be taxed on the gain at the federal rate of 21%. IRC Sec. 11. If the corporation were an S corporation that was not subject to the built-in gain tax, its shareholders would be subject to federal tax, as the result of the pass-through of such gain (IRC Sec. 1366) at the rate of 20% (assuming the surtax on net investment income did not apply).
[xii] Almost a situation of having one’s cake and eating it too. There are some odd idioms out there.
[xiii] IRC Sec. 302(b)(3).
[xiv] Part-sale and part-redemption. See Rev. Rul. 75-447.
[xv] In the case of a cross-purchase, how will Corporation get the cash into S/H One’s hands? A loan?
[xvi] If Shareholder Two also recognizes losses in the year of sale, or it they have carryover losses from earlier years, the amount of gain recognized may be reduced. If Shareholder Two chooses to invest in a qualified opportunity zone fund, their gain recognition may be deferred and even reduced if they satisfy the holding period requirements. IRC Sec. 1400Z-2.
[xvii] IRC Sec. 1031(a). After the Tax Cuts and Jobs Act, this provision is limited to exchanges of real property.
[xviii] Note that a single relinquished property may be exchanged for more than one replacement property. However, be careful of the identification rules in Reg. Sec. 1.1031(k)-1(b) thru (e).
[xix] IRC Sec. 1031(a)(2).
[xx] Reg. Sec. 1.1031(a)-1(b).
[xxi] For example, real property held for sale, or personal property.
[xxii] Which may include relief from indebtedness. Reg. Sec. 1.1031(d)-2.
[xxiii] IRC Sec. 1031(b). No losses may be recognized from a like-kind exchange.
[xxiv] IRC Sec. 701, Sec. 702.
[xxv] An example of the “entity theory” of partnership taxation.
[xxvi] Including an LLC that is treated as such for tax purposes. Reg. Sec. 301.7701-3.
[xxvii] Assume that both the relinquished and the replacement property satisfy the “held for investment” or “held for use in a trade or business” requirement.
[xxviii] N.B. The IRS has not blessed this form of transaction.
[xxix] Not cash.
[xxx] IRC Sec. 731. We assume that neither the mixing bowl rules of IRC Sec. 704(c)(1)(B) and Sec. 737, nor the disguised sale rules of IRC Sec. 707, are applicable.
[xxxi] IRC Sec. 311(b).
[xxxii] IRC Sec. 1374.
[xxxiii] IRC Sec. 1366 and Sec. 1377.
[xxxiv] IRC Sec. 1239. The maximum federal tax rate on ordinary income is 37%.
[xxxv] IRC Sec. 302(a) and Sec. 1001.
[xxxvi] IRC Sec. 355(b); Reg. Sec. 1.355-3.
[xxxvii] IRC Sec. 355. For a description of spin off transactions, generally, including the “active business” requirement, please see https://www.taxlawforchb.com/2020/01/you-can-spin-it-off-or-split-it-up-but-keep-it-active/
[xxxviii] Reg. Sec. 1.1031(k)-1(c). Of course, there is the practical reality that it may be difficult to identify within the 45-day identification period two properties that are desirable, and to acquire such properties within the 180-day replacement period. IRC Sec. 1031(a)(3).
[xxxix] Assume for our purposes that the ownership and rental of the real property constitutes an active trade or business. Reg. Sec. 1.355-3(b)(2)(iv). For more information on this topic, please see https://www.taxlawforchb.com/2016/03/corporate-owned-real-estate-can-it-be-split-off-tax-free-part-ii/.
[xl] Reg. Sec. 1.355-3(b)(3)(i).
[xli] Reg. Sec. 1.355-3(b)(3)(ii); Reg. Sec. 1.355-3(c), Ex. 7 and Ex. 8.
[xlii] There was little-to-no rental activity between the time of sale and the acquisition of the new properties.
[xliii] Of the “fit and focus” variety.
[xliv] PLR-106708-16, May 12, 2016.
[xlv] What? Were you expecting the eponymous Shakespearean play? I’m just a tax guy who quotes lines from Mel Brooks, Monty Python, Austin Powers, and the like.
[xlvi] IRC Sec. 1362.
[xlvii] 37% for the S corporation shareholder vs just under 40% for a C corporation that makes annual distributions of its after-tax profit to its shareholders.
[xlviii] 20% for the S corporation – assuming a sale outside the 5-year built-in gain period – vs just under 40% for the C corporation. Of course, I am assuming that the likelihood of a stock sale is very remote.
[xlix] Beware the disguised sale rule: Reg. Sec. 1.707-3 and 1.707-4.