Many real estate investors have heard of the 1031 exchange, a technique where property held for investment is exchanged for “like kind” property thereby deferring capitol gains taxes until a later tax year. While investors like being able to defer taxes until a later year, many complain that they’d like a way of eliminating capital gains taxes altogether. Another major gripe of 1031’ers is that the proceeds of the transaction must be used to immediately acquire a replacement property. Failing to find a suitable property causes the entire deal to fail and leaves the investor saddled with a large tax bill. Not cool. The solution: an alternate technique, called the 351 exchange. This method allows for both, tax deferral and flexibility to use the transaction proceeds as the investor sees fit.
Here’s how it works: The 351 exchange allows the investor to defer, and maybe eliminate, the capital gains liability on the sale of real estate by exchanging title to the property for stock in a c-corporation created specifically to acquire real estate for resale purposes. No Capital gains taxes are recognized when the real estate passes to the c-corp and the c-corp pays ordinary income, not capital gains, taxes when the property is eventually sold. What’s more, the proceeds from the sale do not necessarily need to be reinvested in more real estate. Unlike a 1031 exchange, the cash resulting when the c-corp eventually sells the real estate can be spent on anything that could be classified as “ordinary and necessary” for the operation of a real estate business. Cool trick huh? Lets take a look under the hood.
Here’s why it works: The property is permitted to pass from the investor free of capital gains taxes due to Section 351 of the Internal Revenue Code. It provides that “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control [at least 80% ownership] of the corporation.”
The explanation of how, and why, the c-corp can sell the property free of capital gains tax is a bit more involved. Generally, you will have a capital gain or loss if you sell or exchange a capital asset. Almost everything you own and use for personal purposes or investment is a capital asset except that property held mainly for resale is not considered a capital asset. IRS Publication 538 tells us that “Stock in trade, inventory, and other property you hold mainly for sale in your trade or business are not capital assets.” The c-corp that you will use to dispose of property in a 351 exchange, was created especially for the purpose of buying real estate for resale meaning that the property is treated as inventory rather than a capital asset. A good understanding of this concept of inventory v. capital asset is key to appreciating the benefit of the 351 exchange. Here are some examples:
• Apartment bldg. rented for income- Capital Asset
• Homes owned by a builder for sale to the public- Inventory
• Merchandise held by a retailer for eventual resale- Inventory
• House owned by a flipper for rehab & resale- Capital Asset
• Office bldg. owned by a doctor to house his practice- Capital Asset
What about taxation on the sale of inventory? I’m glad you asked. Unlike individuals who generally receive income, pay taxes, then pay expenses out of the difference; a corporation earns revenue, deducts expenses, and pays taxes on whatever is left. The name of the game is to have as little left over as possible. The c-corp has the benefit of several well known and perfectly legal methods of handling expenses that are not available to individuals or to other types of business entities. These include things like employee benefit/compensation plans (where you are the employee of course), vehicles, and health insurance, retirement plans, rental of office space plus the accompanying expenses such as utilities and supplies, and of course, to purchase more real estate (for resale), which will also be classified as inventory, not a capital asset
Aren’t C-Corporations subject to double taxation? Therein lies the rub…or so it appears. The subject of double taxation is seen by many planners and advisors as the main drawback with using the c-corp. Double taxation comes into play where after-tax earnings of a C-Corporation are distributed to shareholders as non-deductible dividends. While this is a valid concern in theory, in practice, it really should not trouble most small corporations with earnings under $5 million because of the many deductible ways to pull money out of a c-corp and avoid double taxation such as:
• Employee Compensation Plans
• Interest Payments (including loans you might make to your entity)
• Lease Payments (includes vehicles, equipment, airplanes and real estate)
• Retirement Plans (for you and your family)
• Benefit Plans (including Life and Health Insurance)
• Non-Taxable Reimbursements to you for personal funds you expended on behalf of your C-corporation.
It’s not all upside though By now you’re probably saying, “What’s the catch?” The catch is that the 351 exchange is not right for everyone. Many of us believe that real estate investments are long term commitments, like a marriage, as opposed to trades in the stock market which tend to be short term in nature, like taking home someone you just met at a night club (exciting but often risky and usually short-lived). If you fall into the long-term category, you’re likely looking to trade-up in real estate rather than cash-out. In this case, a 1031 exchange might be more your flavor. The other issue is the cost and somewhat complex process of starting and maintaining the corporation.
While the cost and procedure of setting up a c-corp are not that onerous, there is a bit of formality. Establishing a c-corp will require the filing of certain documents with the State and complying with a few legalities. There will be attorney’s fees involved in getting it off the ground as well as annual fees to maintain compliance. Because of the cost, the 351 exchange is probably better for the larger real estate investors as opposed to the guy that rents out a couple houses.
Final synopsis In the end the 351 exchange might be a great option for investors looking to cash out and use the proceeds for something other than immediately buying another property. But don’t take my word for it. All of you real estate moguls, and moguls to be, should consult with a competent real estate/tax attorney before committing to any transaction.