@103 CHAP ZZ 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� 쿎HOICE OF ENTITY: REAL ESTATE RENTAL BUSINESSES� 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� For many years, small businesses investing in income proper- ty (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 lim- ited to the shareholders' basis for their stock (plus the basis of loans they made to the corpora- tion), 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 candidates for holding real estate. Since the passive loss rules now either prohibit passive losses (ex- cept 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 suit- able, even though cumulative losses are limited to a share- holder'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 corporation may not only be able to take such losses as deductions where ano- ther 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, or even maintains a value beyond its (depreciated) tax basis, there will ultimately be additional tax to pay, if or when the corporation is liquidated someday in the future. This additional tax would include any capital gain on the stock held in the company at time of liquidation, plus capital gains on appreciated real estate in the corpor- ation, and ordinary income ("depreciation recapture") on depreciation deductions taken over the years by the company. @IF167xx]As a company engaged in real estate rental operations, you @IF167xx]could find yourself in a very serious tax trap someday if @IF167xx]@NAME were to become a C corporation. @IF167xx] @IF167xx]Fortunately, this does not now appear to be a problem for @IF167xx]@NAME, currently a @ENTITY. Another disadvantage of operating as a C corporation is that the rental income may be considered "personal holding company" income, subject to a 28% penalty tax if not distri- buted, if the company has significant amounts of other "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 considered "adjusted income from rents," the rental income itself won't cause a problem, but even 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.") @IF166xx](This, however, will not be a consideration in the case of @IF166xx]your business -- although yours is a C corporation, it will @IF166xx]not be considered a "personal holding company," since you @IF166xx]have indicated that no 5 individuals control over 50% of the @IF166xx]stock of @NAME.) Thus, on balance, it is now hard to make any blanket state- ment 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." Hold- ing 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. @IF118xx] @IF118xx]PLANNING POINT FOR @NAME: @IF118xx]旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� @IF118xx]쿌s an S corporation, be sure that if the corporation has pas-� @IF118xx]퀂ive income, such as dividends, interest, rents or royalties,� @IF118xx]퀃hat you obtain competent tax advice as to whether or not � @IF118xx]퀃he special tax on "excessive passive income" is applicable � @IF118xx]퀃o your company. You may be exempt from it, but.... � @IF118xx]� � @IF118xx]쿟he tax consequences of not knowing could be most unpleasant.� @IF118xx]읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� 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 partnership, at least in the case of a new S corporation that is not subject to the tax on "excessive net passive income." 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴커 쿍OTTOM LINE RECOMMENDATION: UNDER CURRENT TAX LAWS,� 쿔NCORPORATING RENTAL REAL ESTATE COULD NOW MAKE SENSE,� 쿌LTHOUGH THIS WAS RARELY TRUE BEFORE THE 1986 ACT. IN� 쿛ARTICULAR, S CORPORATIONS ARE NOW FREQUENTLY A VIABLE� 쿎HOICE FOR HOLDING RENTAL PROPERTIES. BUT CONSULT� 쿧OUR TAX ADVISER BEFORE INCORPORATING YOUR PROPERTIES!� 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴켸