Real Property


Gifts of your real estate can be a bad idea for taxes. What?????? Many of you have probably heard that you should give real estate to your kids to help minimize estate taxes….yes that is still true….but that is only applicable if you have a large estate that will be subject to estate tax.  For most people estate tax is not a real concern.   Thanks to Congress and its ability to get only politics done….we don’t know who is subject to estate tax at the moment. We’ll know that answer at least by the end of 2010 but for now let’s just assume that if you have less than $1,000,000 then you have no estate tax concerns. 

 So if you have no estate tax concerns, a gift of your real estate is not saving your family estate taxes; you are wasting your time and money.  Of course your kids may not feel that way…who doesn’t enjoy ownership in a beach house or mountain cottage. However they may be interested to learn that the gifts can be bad for their income taxes if they ever plan to sell the property.

If you make a gift of your real estate during life instead of passing the property at death, your kids will use the same cost basis you have in the property to determine their income tax if they ever sell the property.  Basically your kids step into your shoes with regard to the built in capital gain in the property.  Admittedly, with the recent real estate turmoil, appreciated property ain’t what it used to be, but there are still plenty of old family farms out there that have vast appreciation built in which has not yet been taxed.  If that property is passed at death, the cost basis is increased to the fair market value of the property and the capital gain is wiped out, at least to the extent the gain is below $1,300,000.  On the other hand, if you transfer the property through gift during life, you loose the benefit of this basis adjustment and your kids will have higher income taxes if they ever sell the property.  This rule is true for all kinds of property (stock, art, etc), but real estate is the most common application.

As with any area of tax law there are some exceptions and special facts which may dictate a different plan of action.  For example, if the real estate is a principal residence occupied by the child, or if the property is expected to appreciate substantially, or if the family is exploring planning to help with medicaid qualification, then these factors may justify a gift even in the face of the potential income tax detriments.  Also, the basis adjustment rules are in flux at the moment and are likely to change further as part of the resolution of the estate tax, whenever that happens.

If you are considering a gift of real estate, make sure you consult your tax advisor first to determine whether you are gaining or loosing any tax benefits.

 

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Many of you have heard about the benefits of owning real estate in a limited liability company (LLC) to provide protection from liability arising out of your ownership of the real property.  See my June 2009 newsletter for further discussion.  This is pretty standard advice that you will hear from most advisors, including me.  However there is one area where the decision to re-title real estate into an LLC is not so clear: real estate owned by husband and wife, particularly where one of them is in an occupation that is exposed to professional liability.

In North Carolina real estate owned by husband and wife as tenants by the entireties is protected from each spouse’s individual creditors.  This means that if one spouse has a judgment entered against them individually, the judgment creditor cannot enforce the judgment against any real estate as long as the real estate is owned by husband and wife as tenants by the entireties.  This can be important, for example, where one spouse is a doctor and subject to potential malpractice liability.        

If real estate is re-titled into an LLC as per the typical advice, then the husband and wife will lose this special protection which only applies to real property; their ownership interest in the LLC will be subject to their individual creditors.  Some of you may be thinking….but doesn’t owning an LLC interest provide some protection against collection from creditors?  Yes it does…but not nearly the protection afforded by the special tenancy by the entireties rule.  Now I am not saying that a husband and wife should never use an LLC for real estate; many of my married clients do.  My point is simply that there are some circumstances where re-titling real estate into an LLC may not be the best choice.  You’ll need to consider the decision on a case-by-case basis.

A few imporant qualifications to note….

1.  This special rule only applies to real estate owned by husband and wife as tenants by the entireties; that is the default type of joint ownership for a husband and wife in NC, but the real estate can also be titled as “tenants in common” which does not afford the special protection.  You need to check your deed to be sure.  Also, if one spouse owned the property before marriage then it is not in tenants by the entireties unless it is re-titled after the marriage.

2.  I am only speaking about NC law.  If you have property in another state, the discussion above is irrelevent for that property, though there may be similar laws which apply in the other state.

3.  The IRS takes the position that it is not bound by this special exception, so it may enforce an individual claim against any property owned by husband and wife.

4.  The protection only applies to individual claims; if both husband and wife are liable for a claim the protection is not applicable.

If you are married and considering an LLC for real estate, make sure you ask about the tenancy by the entireties rule.

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Do you have real estate owned in your corporation?  Watch out for a tax surprise!

Many of you have heard from your advisors (including yours truly) that if you own real estate either for your business or for investment then you need to protect yourself from liability by having the property titled in some form of corporate entity; see my June newsletter.  However, it is very important that you choose the right type of entity to own your real estate.  As a general rule, you should not use a corporation.  Why?  Corporate tax law is not friendly to the real estate owner.

I will spare you a lengthy discourse on the ins and outs of corporate tax laws, although I assure you that it’s fascinating!  The short answer is that real estate owned inside of a corporation generates an unexpected tax liability if you ever wish to move that property out of the corporation.  Let’s say that you acquire a couple of rental properties with a friend and you set up a corporation as the owner, but some years later you and your friend decide to part ways and split up the properties.  This would typically involve dissolving the corporation and transferring property out to each owner.  The problem is that the tax law treats that transfer of property as a “deemed sale.”  If the property has appreciated then that deemed sale triggers a capital gains tax for the corporation.  It is irrelevant that you haven’t actually sold the property or that no cash has changed hands.

For this reason, you should avoid using a corporation to own real estate in most cases.  Keep in mind that I am talking about real estate that you buy and hold (e.g. a location for your operating business, rental or investment property).  If, on the other hand, you are in the business of buying and selling real estate on a short term basis, then a corporation may work perfectly well for your needs, since you will recognize a tax liability anyway when you sell property; there is not the same potential for a deemed sale surprise.

Enter stage left….the limited liability company (LLC).  An LLC is typically taxed as a partnership, which operates under entirely different tax rules.  In particular, real estate can almost always be moved in and out of the name of an LLC without generating a tax liability.  Since the LLC still provides the same basic limited liability protection available in a corporation, the LLC has become the entity of choice for owning real estate.

What about an “S” corporation?  An “S” corporation is, in many ways, taxed like a partnership, however one important difference is that the deemed sale rule described above will still apply for an S corporation.  Although there may be special circumstances that help decrease this tax liability with an S corporation, the better option is to stay away from a corporation altogether.

If you are unfortunate enough to have a corporation that owns real estate already, then you may be stuck with this potential tax issue until you are ready to sell the property.  But please talk to your tax advisors before you take any action; you may have planning options to help minimize the tax liability.

Remember, tax time is no time for surprises.

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Land and inherited by a group of misfits?  POA to the rescue!

Probably one of the worst things that can happen in a decedent’s estate is for a group of beneficiaries who don’t get along to inherit real estate.  Under North Carolina law, beneficiaries  under a Will are generally vested with title to the property as of the date of the decedent’s death, which means the beneficiaries, and not the executor, have the authority concerning sale of the property.   Although Wills often include a provision addressing the executor’s authority to sell real estate, the exact language of the Will is usually insufficient to allow the executor to handle the sale of real estate without involvement of the beneficiaries.  That is, if the real estate is not left to the executor with directions to sell the property as part of the estate administration, then the beneficiaries will inherit the property as tenants-in-common as of date of death.

This means that if the beneficiaries desire to sell the property they must all agree on the terms of the sale and they must all be involved in the execution of the documents.  Imagine the prospect of involving numerous owners in a sale negotiation and then getting them to agree.  Have you ever tried to pick a place to go out to eat based on input from a group of people?  Any interested buyer is going to lose patience pretty quickly unless the decision-making can be delegated.

A power of attorney (POA) is the solution.  The beneficiaries can appoint one individual (known as the attorney-in-fact) with full authority to negotiate the sale of the property and execute all documents including the deed.  This delegation eliminates any required involvement of the beneficiaries — the actual owners of the property.  The attorney-in-fact may be the Executor of the decedent’s estate or one of the beneficiaries or some other party; the key is to find someone who can make a good decision about a sale of the property and who is trusted by all the beneficiaries.

It is important to make sure that all of the beneficiaries as well as the beneficiaries’ spouses sign the POA; this is required under NC law to convey good title to the property.  Also the POA will need to be duly recorded in the county where the real estate is located.  The POA document should ensure that the attorney-in-fact is authorized not only to execute sale documents but also to receive proceeds of the sale on behalf of the beneficiaries.  This will ensure  that the attorney-in-fact can direct the closing attorney to dispose of the proceeds in the most efficient manner.

So what happens if the beneficiaries can’t agree on what to do and are unwilling to appoint an attorney-in-fact?  A mess…a big mess happens.  As tenants-in-common, each beneficiary will effectively have a veto right over any decision concerning the property.  More importantly, any one beneficiary can initiate legal proceedings to force a sale or a severance of the property, in which case the value of the property will likely be reduced for all concerned.  In this case, the POA may still be an option if cooler heads can prevail.

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