Nov
Article by: Jeff Skolnick, CPA, M.S. Taxation
Many homeowners decide at some point, if they are financially able to do so, to convert their personal residence into a rental property. This will create passive income for them but it may come at a price. I am referring to the loss of the exclusion on the sale of a personal residence.
If taxpayers meet certain conditions, one such condition being the home being sold must have been used as the taxpayer(s) principal residence 2 out of the last 5 years, they qualify for an exclusion of up to $500,000 for married taxpayers filing jointly and $250,000 for everyone else.
If you convert to a rental property then you will lose this exclusion, however, if you sell your home to an S corporation you can avoid this situation.
I think the best way to explain this is by example. Let’s say the cost basis of a home owned by a married couple is $250,000 and has a Fair Market Value (FMV) of $700,000. We will also assume that the couple has used this home as their principal residence for 2 of the last 5 years and meets any other tests necessary to qualify for the exclusion stated above. Since this couple is married if they sold their home, they would be entitled up to a $500,000 exclusion. The gain in our example is only $450,000 ($700,000 FMV – $250,000 cost basis). The couple is able to exclude the entire gain. Again, keep in mind if this property is converted to a rental property this exclusion will go away.
If the couple were to sell to an S corporation the tax law requires the sale to be at fair market value. The taxpayers would pick up a gain of $450,000 which would all be excluded, and the S corporation would have a basis in the property of $700,000. The taxpayers have now taken advantage of the exclusion and the S corporation now has a higher tax basis ($700,000), then the individuals would have if they had just converted the residence to a rental property ($250,000). This means increased depreciation for the S corporation.
It is important to note that this absolutely should be done with a tax professional. There are many nuances to this type of transaction, and you must be aware of each of them so everything works the way you would like:
- First you need to Form an S corporation
- Next you need to sell your residence to the S corporation
- If you sell to the S corporation on an installment basis, elect out of installment-sale reporting on your income tax return. In order to take advantage of the home exclusion rules in the tax code all of the income must be taxable in the year of the sale.
- You would elect to utilize the home sale exclusion on your tax return.
I want to reiterate that there are many traps to watch for some of which I am going to list below:
You may have an issue if there is a mortgage on the property. Banks may have a “due on sale” clause which allows them to call the loan upon the sale. There are methods I have read about that can help with this issue, but you must understand the consequences of your mortgage before you enter into this type of transaction.
Make sure you get an appraisal in order to establish the FMV (remember this is a sale between related parties. If you get audited this will be looked at closely).
Make sure title is transferred to the S corporation.
Fill out any other paperwork that you would if you were selling to an unrelated third party.
Some other things to consider are that you will lose the step up in basis upon your passing, however the basis in your stock will be valued at FMV. Again, this is best explained through an illustration. Let’s continue our example. The S corporation purchases the home for $700,000. Let’s say a few years down the road there has been $100,000 of depreciation and the cost basis is now $600,000 and the FMV is $800,000. The asset is owned by an S corporation not the individual taxpayers therefore it receives no step-up in basis upon the death of its shareholder. If the S corporation sells the property for $800,000 there is a $200,000 gain. The $200,000 gain is be passed through to the shareholders. The $100,000 that was depreciated will be taxed at the shareholder level at 25% while the remaining $100,000 profit will be taxed at long-term capital gains rates (again at the taxpayer level)., however those same shareholders will have an $800,000 basis in the stock they received upon the death of the original taxpayers plus the $200,000 gain they paid tax on. If the $800,000 is distributed and the taxpayers liquidate their stock in the S corporation, they will realize a $200,000 loss which would offset the $200,000 gain that flowed through form the S corporation. This is the same result as if the property had been stepped up to $800,000 and then sold for $800,000, no gain or loss.
Another consideration is although there are increased depreciation deductions because the S corporation purchased the property at it’s FMV, taxpayers can usually only deduct rental losses against other passive income such as rental income, or If they have a net loss, against ordinary income if their Adjusted Gross Income is under below certain levels. The amount of loss allowed is a maximum of $25,000 but phases out between $100,000 and $150,000 of Adjusted Gross Income (AGI) ($50,000 and $75,000, respectively, if the individuals are married filing separately).
It is very costly to transfer the real estate back to the shareholder. If the corporation transfers the property back to the seller, then that once again would be deemed a sale at FMV, and the S corporation would report a gain which would flow through to the shareholder.
I did want to mention that selling the home to a C corporation would usually be a bad idea. The reason for this is that in our previous example (when the property sold for a $200,000 gain) the C corporation would be taxed on the $200,000 gain at the corporate level at a rate of 21% (only dealing with federal taxes here, but there would be state taxes also). Upon the distribution of the proceeds to the shareholder ($800,000 less $42,000 of tax = $758,000), the shareholder would be taxed on a $758,000 dividend or if they liquidated their shares in the corporation they would have a capital loss of $42,000 if the sale took place after the passing of the original homeowners because of the stepped-up basis in the stock. Keep in mind a deduction of $42,000 is not an offset to the $42,000 paid. The taxpayers will receive a benefit of $42,000 multiplied by their long-term capital gains rate. The point being, unlike when the home was sold to an S corporation, the tax consequences would not offset each other.
Once again, I am stating this is a very complicated strategy but for those in a certain situation it can be a great tax strategy. Please consult with a tax professional familiar with these rules in order to avoid anything falling through the cracks that would change the results of what you’re trying to accomplish.
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