Obtaining financing when your properties are under a corporation umbrella?

[Aaron K.]

This may be a basic quesstion, but I'm in the beginning stages of researching for my first investment property. For liability purposes, all of my properties will be owed by a corporation that I'll be setting up. I assume that to maintain the security vail, the financing must also have the corporation's name on it - not mine. If that's the case, how do the financing institutions determine credit worthiness? Do they use my credit and assign it to the corporation, or does having my name on the loan not affect the separation between my corporation and my personal liabilities?

[Steven Hamilton II]

@Aaron K. ,

Just to start off, you can look me up and see my credentials. I represent taxpayers such as yourself before the IRS.

Now, on to the fun.

S-corps

Debt is not considered basis therefore you WILL be subject to tax if you distribute proceeds from a cash out refinance or any proceed beyond your exact cash contribution.

Deemed Sale

Typically for a property that you are planning to hold long term, it is recommend that you hold them personally or in a disregarded entity such as an LLC. In many states it can be considered malpractice to advise holding RE long term in a C or S-corp. This is due to the fact any transfer of the property is considered a "deemed sale". This means if you take it out of the corp to keep personally, The corp pays tax on the "gain" between basis and FMV AND you pay tax on the full FMV as a dividend.

I have an examples I will share here:
The corporation will have to recognize a gain/loss on the property. I found a perfect example to give. Assuming no other income and a 5% state tax rate.

I the property was purchased for 500k 10 years ago, and now there has been 200k of depreciation. Meaning adjusted basis of 300k. At sale/dividend Fair Market Value is $1million. There is recapture of 200k. There is then gain of 500k. This would result in tax of $278,841. Plus 5% to state: 35,000

Corporate tax total: 313,841.

The the shareholder that received the dividend would receive a dividend of $1 million. That they would pay 20% on. That would mean a capital gain tax of 200,000 PLUS state tax of 5% = 50,000.

Personal tax total: 250,000

Total tax on dividend/ distribution = $563,841.

This is why it is considered malpractice in some states to advise holding real estate in a C-corp.

You LOSE the Long Term Capital Gain Rates with a corp.

You will pay tax at the corporate rates:

TAXABLE INCOME: TAX:

Over But not over Tax +% On amount over

$ 0 $ 50,000 $ 0 15% $ 0

50,000 75,000 7,500 25% 50,000

75,000 100,000 13,750 34% 75,000

100,000 335,000 22,250 39% 100,000

335,000 10,000,000 113,900 34% 335,000

10,000,000 15,000,000 3,400,000 35% 10,000,000

15,000,000 18,333,333 5,150,000 38% 15,000,000

18,333,333 ............ ............ 35% 0

Skewed Step up in Basis for Heirs

Now, lets say you keep that Rental property in the corporation forever, Yes you can 1031 into something else; however, your kids will not receive much of a benefit as the deemed sale of ANY transfer will cause taxation. The only way around it is a 1031 exchange. Meaning there won't be personal use of the property. The kids will receive a stepped up basis in the corp stock and yes it could be dissolved, but the transfer still causes a sale meaning corp tax due. The dividend would be a return of capital.

Worst one:

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Personal Holding Company Tax
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PHC tax is applied when a corporation is used to hold passive income in an attempt to remove it from an individual's return. This means if the corp has greater than 60% of its income from passive activities than it will be subject to a penalty tax of: 20% in addition to the regular tax rate. Thereby making the base tax rate 35%.

Please ask if you have questions or need clarification.

-Steven