The Different Forms of Holding Property
Let’s go over some of the different forms of holding property since there are several different ways to hold interests and the manner of your holding can alter the tax outcome from both an income and estate perspective.
Fee Simple: Representing the most comprehensive ownership form, fee simple provides the widest range of rights. Owners can freely sell, lease, or bequeath the property. This is the highest form of ownership.
Tenants in Common: Tailored for scenarios with multiple owners, each individual has an undivided interest in the property. Upon an owner's death, their share either follows their will's directives or state intestacy laws, rather than defaulting to the co-owners. In the absence of an entity owning the property, two owners on title who are unmarried typically would hold title as tenants in common. We also call them “TICs” in the real estate world.
Joint Tenancy vs. Community Property:
Joint Tenancy: A frequent point of comparison to Tenants in Common, joint tenancy offers the advantage of the right of survivorship. If one owner dies, their interest directly transfers to the surviving owner(s), sidestepping probate procedures. Another important point to note is that when Spouse A dies, only the decedents interest in the property gets a step up in basis.
Community Property: Exclusive to married individuals or registered domestic partners in select states, property acquired during the marriage or partnership is considered jointly owned. Even if only one party's name graces the title, both have joint ownership. Upon one partner's death, half of the property can be allocated according to their will or trust. An essential difference from joint tenancy is the requirement for mutual consent on property decisions. One further consideration is that when Spouse A dies, both Spouses’ interest in the property are stepped up to the fair market value. This is in contra to joint tenancy, where only the decedent’s interest is stepped up.
Life Estate/Remainder Interest: In this structure, a specific individual possesses the property throughout their lifetime. Post their demise, ownership transitions to a pre-defined beneficiary, known as the remainderman. This is appropriate in scenarios where Spouse B remarries to Spouse C after Spouse A dies but doesn’t want Spouse C to have nowhere to live when Spouse B’s children inherit the property. A life estate guarantees Spouse C can live in the property until to the end of their life.
Leasehold Estate: More than mere renting, a leasehold estate bestows the right to use a property for a specified, elongated period. When the lease concludes, ownership returns to the initial owner. These interests ironically can be very valuable. I can recall a certain retail tenant who engaged in a very long term lease 30 years ago in an area in California that was remote and undeveloped. Later on, that area transformed into a very upscale neighborhood, but because their lease was fixed at such a low rate with such small escalations, they were under market compared to surrounding rents by 80-90%. Each interested buyer in the shopping center they occupied politely requested that this tenant just terminate the lease and the tenant politely responded with a request for $6MM to vacate.
Holding Property in Entities: Those exploring alternatives to personal ownership might consider structures like Limited Liability Companies (LLCs), corporations, or partnerships. These entities potentially offer added liability protection and attractive tax benefits. Notice the underline under the word ‘potentially’. Simply dropping your fee simple interest in a property into a wholly owned LLC will rarely if ever save you taxes. If anything, you’ll likely pay more in franchise tax fees to maintain the LLC with the state it’s organized in. That being said, I use LLCs all of the time for the liability protection and ease of financing with the banks, since they too prefer title to be in an entity format when borrowing with commercial loans.
One quick tidbit I can provide is that owning properties under an entity with a S Corporation election typically is not recommended. The main reason is that S Corporation shareholders do not receive basis in debt used to acquire the property, whereas under partnerships under Subchapter K allocate basis to the partners for acquisition debt. To show how this works, let’s use one example.
Partnership Ownership of a $1,000,000 property with 80% financing, 20% cash. Partners’ basis would be $1,000,000 ($800,000 acquisition debt, $200,000 cash).
S Corp ownership of a $1,000,000 property with 80% financing and 20% cash. Shareholders’ basis is $200,000 only, no basis from the $800,000 loan is to be allocated to the shareholders under Subchapter S rules.
Ultimately, this means that if you engage in a cost segregation study in the above which results in an immediate bonus depreciation deduction under IRC 168(k) and thus results in a IRC 481(a) deduction of $350,000, the following outcomes would occur.
Partnership: $350,000 losses will be allocated to the partners, since they have $1,000,000 in basis, which is sufficient to take the deduction.
S Corporation: $350,000 losses will be limited to $200,000 solely, since the shareholders only have $200,000 in basis. The remaining $150,000 will be suspended and utilized when the shareholders eventually obtain more basis in the corporation, either by earning income or making additional contributions to the Corporation through additional-paid-in-capital.
As always, I’m here to chat with you about your real estate structuring plans.
