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Tuesday, July 17, 2012

Choice of Entity for Real Estate Holdings, A Case Study


What is the best type of entity to hold real estate? I certainly have my opinion on the subject, but in my everyday practice I am often asked to showcase the differences between different entities.

In this article, I decided to focus on several major milestones in the life of a property holder: acquisition, operations and liquidation. While this approach may be somewhat simplistic, I believe it demonstrates major differences between the different types of entities.

Joe is contemplating acquiring an apartment building for $10 million. He is putting a group of investors together who will provide equity of $2 million. Joe secured non-recourse financing for the remaining $8 million. All investors are U.S. taxpayers and do not require any special international tax considerations.

Also, for purposes of this example, let’s assume that all investors are in the highest tax bracket. We will also assume that all investors have sufficient passive income to absorb passive losses allocated to them in any given year.

Under the terms of this deal, the investors are to receive 8% cumulative preferred return on their capital. After they recovered their invested capital (along with their preferred return), the profits and cash from the project will be split 50/50 between Joe and the investors.

Joe feels really good about his project and thinks that in two years he will be able to sell the property for $15 million.

Operationally, the property will generate cash flow of at least $160,000 annually (i.e., enough to return 8% preferred return to investors on an on-going basis) and tax losses due to depreciation of about $130,000, annually. Annual depreciation expense will be $290,000.

How would a different choice of entity affect Joe’s and the investors’ tax situation?

C Corporation
Unlike partnerships, LLCs or S corporations, C corporations themselves are taxpaying entities. C corporation earnings are subject to double taxation: once inside of a corporation, and for the second time upon distributions of the earnings to individual stockholders (dividends). Since the C corporation is a separate taxpaying entity, profits and losses are not allocated to individual stockholders.

In a C corporation environment, the investor group will be holding some type of preferred stock and Joe will be holding common stock to allow him to exercise control over the entity. Clearly, preferred stock and common stock will have different voting and distribution (i.e., dividend) rights to reflect economics of the deal.

Let’s examine the tax consequences of our C corporation’s operations in years one and two. Since the property generated tax losses in years one and two, the corporation itself will not be subject to any income taxes. The losses will stay within the corporation.

However, once the investors receive their annual dividend distributions of $160,000, they will be subject to immediate taxation. Currently, the federal tax rate for the dividends is 15%, however, this rate is scheduled to go up on January 1, 2013 to 39.6% (we will use 39% for purposes of this example). Moreover, effective January 1, 2013, high-income taxpayers will be subject to an additional 3.8% tax on their “unearned income.”

In addition, investors will be paying California tax at graduated rates. For purposes of this example, let’s assume that the blended California rate is 10%. Therefore, in year 2012, the investors will be subject to a cumulative tax liability of $40,000 (i.e., 15% federal and 10% CA tax). In 2013, the investors will be subject to a tax liability of $84,480 (i.e., 39% federal, 3.8% additional tax on unearned income and 10% CA).

Based on our facts, at the end of the second year, the property will be sold for $15 million. Taking depreciation into account, the gain on sale would be $5.580 million ($15 million sales price less acquisition cost of $10 million, which itself is reduced by two years of depreciation of $290,000 per year). At this point, C corporation will be able to utilize the losses generated in years one and two. As such, taxable income inside of the corporation will be $5.320 million (gain on sale of $5.580 million less two years of losses of $130K). Corporate level tax will be calculated as follows:

Taxable income

$5,320,000

Tax rate (combined, rounded Fed and CA)

43%


Corporate tax liability

$2,287,600

Let’s take a look how much cash is left to distribute to all the parties involved:

Cash proceeds (ignoring closing costs)

$15,000,000

Less loan repayment

$8,000,000

Less corporate tax liability

$2,287,600


Left to distribute

$4,712,400

The remaining cash will be distributed as follows:

Return of capital to investors

$2,000,000

Remainder 50% to investors

$1,356,200

Remainder 50% to Joe

$1,356,200

As mentioned above, profit distributions to investors and Joe will be treated as dividends and will be taxed to the shareholders. Using the same projected 2013 tax rate as above, the total combined tax liability for Joe and investors would come to $1,432,147 ($2,712,400 combined dividend distribution times combined rate of 52.8%).

To summarize, over the life of a project, the total after tax cash flow from a project (net of returned capital) available to all the players would be $1,475,773.

S Corporation
S corporations do not allow for different classes of stock and all income earned by S corporations must be allocated pro-rata among their shareholders. All distributions must also be made on a pro-rata basis. Therefore, S corporations will not accommodate the economics of this deal, as it will not allow for preferred returns.

Limited Liability Companies (LLC) or Partnerships
While legally there are some differences between LLCs and partnerships, in terms of income taxations, these two types of entities are virtually identical. Hence, I will use the term “partnership” for purposes of this discussion, but the same logic will apply to LLC.

Partnerships are flow-though entities. The income (or loss) of a partnership is calculated on an entity level and then allocated to individual partners based on the economic deal, who, in turn, pay tax on their allocable share of partnership income. Hence, partnership earnings are only taxed once. Distribution of cash is generally not subject to tax (unless it exceeds partner’s basis in a partnership).

While the discussion of basis is beyond the scope of this article, let me just say a few words about it. The concept of basis is crucial to understanding partnership taxation. Individual partners cannot utilize tax losses flowing through them if such tax losses exceed their basis in a partnership. Moreover, all distributions of cash in excess of basis are subject to tax.

Let’s take a look at the operations in year one and two. Both years produced tax losses and preferred return cash flow to the investors. In both years, losses will be allocated to the investors ($130,000 per year) and in both years they will receive cash distributions of $160,000 per year.

Total investment in partnership:

$2,000,000

Allocable share of debt:

$8,000,000


Total basis before losses and distributions

$10,000,000

Less allocated losses in years 1 and 2

($260,000)

Less distribution in years 1 and 2

($320,000)


Net basis at the end of year 2

$9,420,000

As you can see, not only investors can utilize losses. Currently, they are also subject to tax on their current distributions since at the end of both years they have sufficient basis to absorb both of them. But what will happen if the property is sold? As calculated in the C corporation section above, gain on sale of the property will be $5,580 million. However, since a partnership does not have an entity level tax, cash available for distribution will be $7 million ($15 million sales price less loan repayment of $8 million). The gain will be allocated to individual investors as follows:

To the investors to the extent of prior losses:

$260,000

To the investors to the extent of prior distributions:

$320,000

50% of the remainder to the investors:

$2,500,000

50% of the remainder to Joe

$2,500,000


Total gain

$5,580,000

Cash would be distributed as follows:

To the investors to the extent of their
invested capital

$2,000,000

Remainder—50% to investors

$2,500,000

Remainder—50% to Joe

$2,500,000


Total

$7,000,000

Investors will be taxed on their allocable share of the gain. Based on the calculations above that share is $3,080,000 ($260,000 + $320,000 + $2,500,000), of which $580,000 will be taxed at the highest federal rate and the remainder will be taxed at a special federal capital rate of 20% (please note, that the reduced capital rate is not available to C corporations). Therefore, investors’ tax liability based on the projected rates in 2013 will be $1,151,240, leaving them with the net cash of $1,928,760. Joe’s combined tax liability will end up at $845,000, which leaves him with the after tax cash flow of $1,083,760. Therefore, combined after tax cash flow available to all the partners will be $3,012,520 as compared to C corporation shareholders of $1,475,773.

As you can see, partnership structure provides superior tax results to that of a C corporation. In addition to pure monetary incentives, the partnership structure also provides more flexibility and ease in annual governance.

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