This one is for the business owners out there. If your business owns the real estate that it occupies and your business is taxed as a regular C Corporation, you’re going to love this column.
IRS makes you pay tax twice on income from a C Corporation. First when the business earns it, and again, when the owner takes money out (called dividends). Ouch! But wait, when it comes to paying rent, the business gets a deduction (reducing its taxable income) and the owner reports the rental income. Bonus, the owner gets to deduct depreciation against that rent. That could be enough to wipe out all the taxable rental income! This works for all property used by the business, not just real estate. But in our example today, I’m going to focus on real estate.
Let’s imagine your company purchased its real estate years ago and the remaining depreciation to take is low or even zero. Let’s also imagine your company needs some working capital for an expansion project. In our example, your real estate is now worth $1.5 million. The company could attempt to borrow from the bank, and the interest paid on that loan would be a tax deduction, but remember the building is no longer providing a depreciation tax benefit.
Solution: Purchase the real estate from your company at an arms length price. (Get an appraisal.) You borrow from a bank to assist as much as possible in the purchase. Your company now has a cash infusion of $1.5 million, but has to pay tax on the gain on the sale. At a flat 21% corporate tax rate, let’s assume the gain is $1.2 million. The tax would be $252,000. That would leave almost $1.3 million for the expansion project. (Probably about as much as a bank would lend.) You now rent the real estate to your corporation at a fair rate. (Once again, use a third party to determine that.)
The rent is an expense, reducing taxable income for the corporation. The rent is income to you, BUT, you now have depreciation expense of about $33,000 a year that reduces how much you report as taxable income personally. You also get to deduct the interest paid to the bank, so usually, your rental income ends up being tax free. Voila! Your business has an infusion of cash, you are taking money out of the corporation without paying a double tax and between you and the corporation, $33,000 a year of additional depreciation expense has now been created.
When you ever decide to sell that business real estate down the road, it will most likely have appreciated in value, and the undepreciated portion gain will be taxed at favorable Capital Gains Tax Rate. What a deal!
Remember earlier I mentioned that this isn’t just for real estate? You could do this for large business equipment too.
Have you heard? Prov 24:27 says, “Prepare your work outside; get everything ready for yourself in the field, and after that build your house.”
Kelly Bullis is a Certified Public Accountant in Carson City. Contact him at 882-4459. On the web at BullisAndCo.com. Also on Facebook.
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