24961 The Old Rd, 2nd FloorStevenson Ranch, Ca 91381

Ronald D. Morgan, CPARon@sksm.comTel: (661)286-1040Fax: (661)286-1050

TOOLS for SUCCESS

C-REX.org

June 14, 2007

Why does it matter how real Why does it matter how real estate is owned?estate is owned?

First, let’s look at a married couple:First, let’s look at a married couple:

John H.John H. purchased his home in 1987 for purchased his home in 1987 for $150,000. In 1995, John married Paris and $150,000. In 1995, John married Paris and they bought a new home together for they bought a new home together for

$300,000, $300,000, and rented out his old home. and rented out his old home. In 2007, John died. Let’s assume theIn 2007, John died. Let’s assume therental home was worth $1,000,000, and rental home was worth $1,000,000, and

their their residence was worth $1,500,000. residence was worth $1,500,000.

This presentation will be solely concerned This presentation will be solely concerned with income tax effects.with income tax effects.

First Situation:First Situation:

John did not change his vesting John did not change his vesting title on his rental propertytitle on his rental propertywhen he got married, butwhen he got married, butthey used the rent moneythey used the rent moneyto enrich their joint to enrich their joint lifestyle. When he and Parislifestyle. When he and Paris bought their new home, they bought their new home, they held it as “Joint Tenants”.held it as “Joint Tenants”.

So, it appears that John “co-mingled” his So, it appears that John “co-mingled” his rental income, thus making the property a rental income, thus making the property a

community asset.community asset.

Upon someone’s death, most of their Upon someone’s death, most of their assets get a new income tax basis.assets get a new income tax basis.

So, Paris’ tax basis is as follows:So, Paris’ tax basis is as follows:

Rental PropertyRental Property $1,000,000$1,000,000

ResidenceResidence $ 900,000$ 900,000 (½ of $300,000 plus ½ of $1,500,000)(½ of $300,000 plus ½ of $1,500,000)

If Paris sold these two properties in 2008 for the same If Paris sold these two properties in 2008 for the same

values, then she would not have any income taxes values, then she would not have any income taxes due on due on

the rental property, and would have a taxable gain of the rental property, and would have a taxable gain of

$600,000 on her residence. If she used her $250,000 $600,000 on her residence. If she used her $250,000

exclusion, she would owe capital gains taxes on exclusion, she would owe capital gains taxes on $350,000.$350,000.

Second Situation:Second Situation:

Assuming the same facts in the first situation, Assuming the same facts in the first situation, except that they held title as “Community except that they held title as “Community

Property with right of survivorship” for both of Property with right of survivorship” for both of their properties.their properties.

Community Property gets a double step up in basis. Community Property gets a double step up in basis. So, Paris’ tax basis becomes:So, Paris’ tax basis becomes:

Rental PropertyRental Property $1,000,000$1,000,000Residence Residence $1,500,000$1,500,000

If Paris were to sell the properties, she would not If Paris were to sell the properties, she would not have anyhave any

income taxes to pay.income taxes to pay.

Third Situation:Third Situation:

John and Paris were not married, and they held their John and Paris were not married, and they held their residence as “Tenants in Common”.residence as “Tenants in Common”.

Since John owned the rental property himself, then Since John owned the rental property himself, then the value would get a complete step up in basis, the value would get a complete step up in basis, while the residence would only get a ½ step up. while the residence would only get a ½ step up. So, the result is the same as the first situation:So, the result is the same as the first situation:

Rental Property:Rental Property: $1,000,000$1,000,000

Residence:Residence: $ 900,000$ 900,000

John and Paris set up a revocable John and Paris set up a revocable living trust and transfered all of their living trust and transfered all of their

assets into it.assets into it.

The tax basis does not change in this The tax basis does not change in this situation (see prior situations for situation (see prior situations for

specifics).specifics).

Fourth Situation:Fourth Situation:

Fifth Situation:Fifth Situation:

John and Paris set up an S-corporation for John and Paris set up an S-corporation for the rental property.the rental property.

Here, the tax situation gets complicated. At Here, the tax situation gets complicated. At John’s death, the S-corporation stock gets John’s death, the S-corporation stock gets

a step up in tax basis, not the rental a step up in tax basis, not the rental property. So, Paris would not get the property. So, Paris would not get the

added benefit of additional depreciation added benefit of additional depreciation on this property. However, assuming the on this property. However, assuming the stock was held as community property stock was held as community property

(and no other assets/liabilities were in the (and no other assets/liabilities were in the corporation), she would enjoy a corporation), she would enjoy a

$1,000,000 income tax basis in the stock. $1,000,000 income tax basis in the stock.

Sixth Situation:Sixth Situation:

John and Paris set up a C-corporation for the rental John and Paris set up a C-corporation for the rental property.property.

The tax situation is the same as in the previous The tax situation is the same as in the previous situation. Only the stock gets a step-up in the situation. Only the stock gets a step-up in the

basis. However, Paris would also have potential basis. However, Paris would also have potential double taxation when the property was sold since double taxation when the property was sold since the corporation would pay taxes at the corporate the corporation would pay taxes at the corporate

level, and then Paris would pay personal taxes level, and then Paris would pay personal taxes when the profits are distributed to her. when the profits are distributed to her.

Seventh Situation:Seventh Situation:

John and Paris set up an LLC for the John and Paris set up an LLC for the rental property.rental property.

Here, Paris will get a complete step up in Here, Paris will get a complete step up in the income tax basis on the rental the income tax basis on the rental property. Assuming Paris makes a property. Assuming Paris makes a

special IRS election (Section 754), she special IRS election (Section 754), she will also enjoy increased depreciation will also enjoy increased depreciation

deductions based on the new value. The deductions based on the new value. The answer is the same if the happy couple answer is the same if the happy couple

had set up a general or limited had set up a general or limited partnership.partnership.

Eighth (and last) Situation:Eighth (and last) Situation:

John and Paris set up an irrevocable trust and John and Paris set up an irrevocable trust and contributed the rental property to it.contributed the rental property to it.

There are many types of irrevocable trusts, There are many types of irrevocable trusts, however, the answer is usually the same. The however, the answer is usually the same. The trust’s assets do not get a step up in it’s basis. trust’s assets do not get a step up in it’s basis.

So, when it is sold, generally there will be a So, when it is sold, generally there will be a capital gain. If the beneficiary is a non-taxable capital gain. If the beneficiary is a non-taxable

entity (e.g. charity), then no taxes are due. entity (e.g. charity), then no taxes are due. However, if the beneficiary is taxable (e.g. However, if the beneficiary is taxable (e.g.

children), then the taxes will be due.children), then the taxes will be due.

As you can see, how title is held on real As you can see, how title is held on real estate can make a significant difference estate can make a significant difference

in the amount of income taxes paid. in the amount of income taxes paid.

24961 The Old Rd, 2nd FloorStevenson Ranch, Ca 91381

Ronald D. Morgan, CPARon@sksm.comTel: (661)286-1040Fax: (661)286-1050

TOOLS for SUCCESS

C-REX.org

June 14, 2007