C-corp shareholder takes over home built by corp

[MJG CPA]

Sole shareholder c-corp home builder built a spec house before real estate market went bust. Can't sell house; can't pay off construction loan, so moves into home in order to get a mortgage as individual. Builder is now on hook personally to pay for the house. House still listed for sale, but real estate market flooded in our area and no takers.

My question is how to treat this ownership transfer for the corp tax return? House would have been inventory to the corp prior to transfer out. Do I simply convert this to a personal asset and show it as if the house were sold by corp to the shareholder at cost? Does it matter that the mortgage was taken for more than the cost of the construction.

Any ideas??? :blink:

[jainen]

>>show it as if the house were sold by corp to the shareholder at cost?<<

Not quite. It is a sale at FMV.

>>Does it matter that the mortgage was taken for more than the cost of the construction. <<

Yes, it matters. It proves that FMV exceeds basis, and the corporation has taxable gain.

[MJG CPA]

>>show it as if the house were sold by corp to the shareholder at cost?<<

Not quite. It is a sale at FMV.

>>Does it matter that the mortgage was taken for more than the cost of the construction. <<

Yes, it matters. It proves that FMV exceeds basis, and the corporation has taxable gain.

Help me understand why FMV should be used. Why should client pay corp tax on a sale to himself? Can't client simply assume carryover basis and pay tax on gain when sold? The corp received no proceeds from sale, so has no wherewithal to pay tax. Doesn't the tax usually follow the money?

[jainen]

>>Doesn't the tax usually follow the money?<<

Yes, but not for related parties. IRC 311b is pretty clear about this. It was not "a sale to himself" because he chose to put the property in a separate entity. Now he is stuck with that choice, just like he is stuck with his decision to keep building in "a real estate market flooded."

Don't tell me there's no "wherewithal to pay tax." He MADE money on this deal. Maybe not as much as he hoped for, but that's what the word "spec" is all about. Another way to look at it is that he acquired a nice new personal residence at a bargain price, courtesy of his corporation. Nothing wrong with that, of course, but according to the regs it was a taxable transaction. Or are you suggesting he was not actually operating a business, but was simply building a house for himself?

[MJG CPA]

Don't tell me there's no "wherewithal to pay tax." He MADE money on this deal. Maybe not as much as he hoped for, but that's what the word "spec" is all about. Another way to look at it is that he acquired a nice new personal residence at a bargain price, courtesy of his corporation. Nothing wrong with that, of course, but according to the regs it was a taxable transaction. Or are you suggesting he was not actually operating a business, but was simply building a house for himself?

Where is the bargain if he's claiming a sale at the full mortgage price.

I guess where I'm getting hung up is that the only "profit" made came from the bank via the mortgage which all has to be repaid.

Assume the house cost the corp. $200,000 to build and the mortgage taken on the transfer to the individual was $250,000. One assumes that if a bank will lend you $250,000, then the house must be worth that, but I'm not so sure. I've seen the house, and it won't sell for $250,000, even when the market was good. If it would have, then he would have sold it. Also, the assessed valuation per the tax assessor is only $220,000 and tax assessments in this area are typically at the high end of market.

Does it necessarily follow that the sale price should be established at the $250,000 mortgage price, or maybe I'm over-reading your meaning?

To me, it seems like the mortgage represents two transactions condensed into one: An initial mortgage for whatever the true market value of the house is and a secondary home equity loan. Just because he got a bank to lend him top dollar on the home, doesn't mean the house is worth $250,000. People take "equity" out of their homes all the time and end up "upside-down" on their mortgages, which I'm sure this guy is. That's why I'm hesitant to use the mortgage value of $250,000 as FMV for purposes of establishing the sale.

How would this be different than any other Joe who goes to the bank and gets a home equity loan or a mortgage refinance to pull equity out of their home? That doesn't constitute a taxable event, so why is his $50,000 loan proceeds considered profit?

This is making my head hurt.

[JohnH]

If you use a FMV less than the $250K, then you should have it backed up very well with independent appraisals or other third-party evidence. Of course, if you do document a FMV less that the $250K loan amount, you need to take into account there could be big problems with the lender if the loan defaults, because the client probably provided the bank all sorts of documentation to prove a FMV greater than $250K in order to induce them to loan him the money in the first place.

Looks like your client is stuck on the horns of a dilemma, and you probably need to be careful you don't find yourself in a similiar position by trying too hard to help him out. People who get into desperate straits sometimes take others down with them, even when they don't intend to do so.

[MJG CPA]

Point well taken.

[jainen]

>>the mortgage represents two transactions condensed into one: An initial mortgage for whatever the true market value of the house is and a secondary home equity loan<<

What an amazing statement! Pure fiction, MJG. That's not what happened at all, and you and your client both know it well. He got ONE mortgage, a purchase-money loan. Maybe it was 80 or 90 or even 100%, but nobody believes a bank gave him more money than the house was worth. Your statement that "tax assessments in this area are typically at the high end of market" is just as unbelievable--if it were true, the county would have tens of thousands of lawsuits and the assessor would quickly be voted out of office.

I know you are trying to help this guy, but be realistic. Whatever his original intention was, the result is that he decided it was better to keep the house for himself than sell it for such a small profit. The bargain is that he takes it with a low basis, and if the market improves he can expect to exclude gain under Section 121, a much better deal than the double taxation of a C-corp's ordinary income. Don't pretend he hasn't figured this out. The way he set it up, it didn't even cause a short-term cash flow problem, and he ended up with a lower interest rate than the construction loan, didn't he? I'll bet a lot of builders around there would think it's a dandy solution, even if there is a little tax bill in the middle of it.

By the way, when you said "follow the money" were you thinking about the loan proceeds that exceeded the amount to pay off construction costs? That was profit, was it not? And the tax is only a percentage of that profit, so please explain why he doesn't have the "wherewithal to pay tax." As you say, he has to make mortgage payments but that's just like any other buyer. The SELLER doesn't have to pay the mortgage back.

[jainen]

>>Whatever his original intention was<<

Since you called this a spec house, I'm going to speculate about it. I have absolutely no basis for any of this fantasy, but here's what the cynic in me says:

I think he intended to live in it all along. He knows you can use Section 121 every two years, which is not much longer than it takes to build and market a nice home. Like many independent builders, he's already done it two or three times before.

The market downturn is a neat excuse but it didn't catch him by surprise. The signs were everywhere--it's how he got such a good deal on the building lot. In fact, the market was "flooded" partly BECAUSE people just like him were putting up spec houses before there was an established need.

To suit himself, he dressed it up pretty which helped him bulldog the mortgage company into what was basically a cash-out refinance, thus providing tax-free funding for his next project. At the same time he used the excuse of a slow market to convince the assessor to go with construction costs since there was no arms-length sale.

Now he also wants to use the slow market to recharacterize his plan into some kind of non-taxable shareholder basis adjustment. Unfortunately, there is no statutory authority for that approach.

The cynic in me is tired from watching the election today, so I won't get into whether deducting construction costs on the corporate side and rolling the resulting basis into a Section 121 exclusion is double-dipping.

[MJG CPA]

The bargain is that he takes it with a low basis, and if the market improves he can expect to exclude gain under Section 121, a much better deal than the double taxation of a C-corp's ordinary income.

I still don't get it - where is this low basis you're talking about? If we use the full $250,000, that is his basis.

You are undoubtedly a cynic - not that there's anything wrong with that - BUT:

1) The corporation got its construction loan paid off period, so is at a break-even. The loan proceeds went to the individual, not the corporation. So where does the corp come up with tax on a $50,000 gain?

2) He didn't convince the assessor of anything. Our county has just implemented a new computerized valuation system that calculates the value of all properties within the county, based on sq. footage, age, construction materials, etc. The assessor is now merely a field person who takes measurements, but doesn't get to assign the value and the computer is not influenced by any amount of politicking. I still hold the property is not worth $250,000 even if a bank was foolish enough to lend that much.

But that also doesn't mean I'd be willing to put my neck on the line for it, because I can't prove it's not worth $250,000.

Still, I want to know about this low basis, though.

[jainen]

>>The loan proceeds went to the individual, not the corporation.<<

Well, that's his problem. Sounds like he took the property plus an extra fifty grand, which is therefore taxable to him as well as the company. Yep, double taxation on C-corp earnings; no surprise there. Look at the escrow papers--he told the bank he was buying it for this much money. That means the corporation was selling it for this much.

His basis (using your example figures) is $250,000, or more likely the $250,000 mortgage is only 80% of his basis. That is very low, because when he started this project he probably hoped it would be worth twice that. If he bought the house himself at that time, his basis would be 500K with no room to exclude gain on sale. The corporation would make a quarter million dollar profit and be double-taxed accordingly. But as it turns out, he picks up the property for little more than construction costs. Now if the market recovers in a year or two, he will still make that quarter mil but it will all be excluded under Section 121. What a coincidence!

>>where does the corp come up with tax on a $50,000 gain?<<

I already answered that. It's IRC Section 311b. Suppose there were 100 shareholders. One couldn't just take the corporation's assets for personal use without some kind of tax effect, could he? Partners, maybe, but not a shareholder.

If you don't want to call it a sale, it has to be wages/benefits or a dividend. Maybe it could be a return of capital, but that doesn't fit the facts, especially since someone this heavily financed doesn't have that much basis in his stock. Even so, that just determines whether it's taxable income to the shareholder. There is no way to call it a tax-free distribution. Under 311b it's still FMV minus basis (or rather, COGS) for the corporation in any case.

>>based on sq. footage, age, construction materials, etc. <<

Those numbers will always undervalue residential property, which carries a subjective element variously called amenities or pride of ownership or something. In a falling market the local assessment can trail the actual curve, but not for new assessments. As you point out, you can't even show that the true value is not 15% HIGHER than the new assessment, in spite of the fact that his marketing plan (whatever it was) did not succeed.

>>the computer is not influenced by any amount of politicking<<

NOW who's being cynical?

[MJG CPA]

more likely the $250,000 mortgage is only 80% of his basis. That is very low, because when he started this project he probably hoped it would be worth twice that. If he bought the house himself at that time, his basis would be 500K with no room to exclude gain on sale. The corporation would make a quarter million dollar profit and be double-taxed accordingly.

You're obviously used to much higher-priced real estate. We are in a very rural area of IL, where a $250,000 house is in the upper percentile of home sales. There are very few sales over that unless there is acreage involved which there is not with this house. In my opinion, even when the real estate market was booming, the most he could have sold that house for is about $275,000.

Anyway, thanks for your feedback. You've given me something to think about. :)

[jainen]

>>the most he could have sold that house for is about $275,000.<<

Now wait just a minute--you mean he risked $200,000 building a house with no prospective buyer in a fragile market that at best would have only grossed a 38% return before carrying costs and sales expenses? Now I KNOW he's lying and intended to occupy it all along, taking business deductions for his personal expenses.

Well, he didn't do his homework, so now he has double taxes at ordinary rates for a profit on a house he didn't even sell and a premium mortgage whose leverage means if this "flooded" market should drop 10% his entire equity would be 100% wiped out. I hope he enjoys the quiet country life because it sounds like not too many other people want to move there.

[jim@lwr]

Isn't there another tax due that no one has talked about?

If the shareholder received a home that is worth $250,000 and only paid $200,000 doesn't he have a dividend of $50,000?

[jainen]

>>doesn't he have a dividend of $50,000? <<

Yes, I didn't make that clear. Even though the mortgage was $250K, he only gave $200K of it to the corporation (to pay off the construction loans). So the corporation has a taxable net profit of $50K and the shareholder has a dividend (or wages) of $50K and the best you can do is say it was the same 50K.

Actually, it seems the true sales price was a FMV of $275K, with a 90% loan. If that's what the escrow papers say, the corporation profit was actually $75K, and the shareholder is likewise dinged for $25K more because he retained the down payment.

According to MJG, this sale occurred at the peak of the market so he didn't do too bad on the corporate side. Personally, he got a brand new home, fifty grand in his pocket, and didn't have to pay a Realtor's commission or even shell out for a down payment. They also gave him a break at the county building, so all-in-all I think he's doing just fine.