April 19, 2022
Businesses that need real estate to conduct operations, or otherwise hold property, traditionally have put the title to the property in the name of the business itself. But owners are increasingly rethinking this approach. Many are recognizing that any short-term benefits may be outweighed by the tax, liability and estate-planning advantages associated with separating real estate ownership from the business.
Businesses that are formed as C corporations treat real estate assets as they do other business assets, such as equipment and inventory. Any expenses related to owning those assets appear as ordinary expenses on their income statements and are generally tax deductible in the year they’re incurred.
When the business sells the real estate, though, the profits are taxed twice — at the corporate level and at the owner’s individual level when a distribution is made. This double taxation treatment is avoidable, though. Specifically, if ownership of the real estate were transferred to a pass-through entity, the profit upon sale would be taxed only at the individual level.
Separating the ownership of your business from its real estate also provides an effective technique for protecting it from creditors and other claimants. For example, if your business is sued — for anything from malpractice to breach of contract — and found liable, the plaintiff may go after all of the business’s assets, including any real estate held in its name. Plaintiffs can’t touch property owned by another entity, though.
The strategy also can pay off if your business is forced to file for bankruptcy. Creditors generally can’t recover real estate owned separately unless it’s been pledged as collateral for credit taken out by the business. That means you can liquidate the company and then sell the real estate, usually reaping the property’s fair market value, free and clear.
More Estate-Planning Alternatives
The ability to separate real estate from a business gives you some additional estate-planning options, too. For example, you can gift your interest in the business but hold on to the real estate. Rental payments on the property could supplement your retirement income.
If the company is a family business but not every member of the next generation is interested in actively participating, separating property gives you an extra asset to distribute. You could, for example, bequest the business to your daughter and the real estate to your son.
How to Separate Real Estate
The execution of this strategy is relatively simple. The business simply transfers ownership of the real estate, and the transferee leases it back to the company.
So who should own the real estate? One option is for the owner of the business to purchase the real estate from the business and hold title in his or her name. The concern is that it’s not just the property that will transfer to the owner, but any liabilities related to the real estate also will transfer.
Moreover, any liability related to the property itself could inadvertently put the business at risk. If, for example, a client or vendor suffers an injury on the property and a lawsuit results, the property owner’s other assets (including the owner’s interest in the business) could be put in jeopardy.
An alternative — and generally preferable — approach is to transfer the property to a separate legal entity formed to hold the title, typically a limited liability company (LLC) or limited liability partnership (LLP). With a pass-through structure, any expenses related to the real estate will flow through to your individual tax return and offset the rental income.
An LLC is more commonly used to transfer real estate. It’s simple to set up and requires only one member. If the LLC has multiple members, you can include buy-sell provisions and other transfer restrictions in the operating agreement. Distributions are made at the discretion of the managing member rather than on a pro rata basis, as in partnerships. And, importantly, the personal assets of an LLC’s members generally are shielded from the LLC’s creditors.
LLPs require at least two partners and aren’t permitted in every state. Some states restrict them to certain types of businesses. Where allowed, they may be more costly to establish because you might be required to set up both the partnership and another entity that will serve as the general partner. Further, some states limit the protection of partners’ personal assets.
Proceed with Caution
Separating the ownership of the business’s real estate isn’t advisable for every company. If it’s worthwhile, the right approach to separation will depend on your individual circumstances. Contact your tax and legal advisors to help determine the best approach to minimize your transfer costs and capital gains taxes while maximizing the other potential benefits of separate ownership.