Fall 2014 Newsletter - Property Divisions: Avoiding a Common Unwelcome Surprise

By Stephen Bravo, Apogee Business Valuations, Inc.

Mr. Bravo wishes to thank Michael Mattson for his assistance and insights with this article.

Let’s assume the following:

  • A couple is getting divorced.
  • There are no children.
  • Each spouse is fully capable of earning future compensation so there is no need for alimony.
  • All marital assets have been properly identified and disclosed in the Rule 401 financial statements.
  • The parties agree to divide the marital assets equally, and, up to now, there has been no disagreements regarding the market value of any of the marital assets.
  • But for two assets, all marital assets have been assigned to a spouse, and everyone (including the attorneys) are in agreement with how the assets have been divided.

Let’s further assume that the two remaining assets are both commercial real properties – “Property A” and “Property B.”  For purposes of this illustration, Properties A and B are identical in all respects, such as building age, quality of location, physical condition, quality of tenants, rental income, collection of rents, rental expenses, quality of property management, no outstanding bank debt (debt-free), etc.  Based on current real estate appraisals each property is worth $10 million.

Question: Should the husband and wife be indifferent about who receives which property, since they both appear to be worth the same amount?  Is there additional information needed to make an informed decision?

Both parties’ attorneys, knowing that nothing is quite as simple as it appears, decide further discovery is warranted, and learn the following:

  • Property A is owned by a C (convention) corporation[1] in which the spouses are equal shareholders.
  • Property A was purchased many years ago for $5 million. At that time the purchase price allocation assigned $4.5 million to the building and the remaining $500 thousand to land. The building is now fully depreciated.[2]
  • Property B was recently acquired for $10 million, and is owned jointly and directly (i.e., there is no intervening entity) by both spouses.  $1 million is attributable to the land, with the remainder to the building.
  • Both properties are expected to appreciate in value at the same rate – 4%/year and have the same level of investment risk – an 8% (discount rate).

After uncovering this important information, the couple’s financial advisors analyze the information.  It becomes clear that there is a very large difference in the properties’ “values,” all of which is attributable to potential tax liabilities. 

In particular, owning property through C Corporation stock subjects the corporation to income taxes at ordinary corporate income tax rates for any realized capital gains upon sale of the property.[3] 

Owning property outright subjects its owner to several possible taxes upon its sale: 1) depreciation recapture[4], on the total amount of depreciation taken by the property’s owner, 2) capital gains, on the gains in excess of the total depreciation taken on the property and 3) net investment income tax, which is an additional tax levied as a result of the gain.[5]  But, because the property is new it can be depreciated (assume over 20 years); so there is a tax benefit each year.

The following table shows the expected tax rates related to owning each of the Properties.

 

C Corporation

Outright Ownership

Federal

   Ordinary Income

34.0%

39.6%

   Depreciation recapture (Sec. 1250)

N/A

25.0%

   Capital gains

34.0%

20.0%

   Net Investment Income

N/A

3.8%

State

   All income (including capital gains)

8.0%

5.0%

C Corporation Ownership

Assuming the property appreciates (at a rate of 4%/year) over time, the corporate income taxes owed upon the sale of Property A, in any year for the next 30 years, is shown in the following graph:

As of the first day of owning the C Corporation stock, the capital gains taxes are $3.73 million; so the $10 million stock value is really worth considerably less.  Of course, these corporate income taxes are paid only if the property is sold; but, as shown in the above chart, they do not diminish over time (assuming continued appreciation).  In fact, they increase every year. After thirty years, the potential taxes on the gain rise to more than $12.5 million.[6]  Regardless of the holding period expected (e.g. sell in 5 years, or sell in 10 years, or sell in 30 years), we must consider the present value of these potential taxes over the same period (using an assumed discount rate of 8%). As the following graph illustrates, the value of these taxes diminishes.[7]

As seen above, each year the present value of the corporate taxes decreases. However, even with this decline, the present value of the taxes are still over $1.2 million thirty years from now, which is not insignificant after a very long time.

Outright Ownership

The sale of Property B will trigger income taxes only at the individual level. The total income taxes (a combination of the three enumerated earlier) payable upon sale of the Property B, in any of the next 30 years, is shown in the following graph:

In contrast to the taxes on Property A, those on Property B begin at $259 thousand and rise to over $9.2 million.  And, of course, the present values of these taxes will also be less than those for Property A.  However, when we include the tax benefits that arise due to the ability to depreciate Property B, the picture changes significantly: 

While the taxes on the sale of Property B increase over time, they are more than offset by the cumulative tax benefit due to the ability to depreciate the property.[8]

The contrast between the two can be seen in the following chart, which really highlights the difference:

As a result of this analysis the couple’s financial advisors realize that Properties A and B are not very similar at all, with respect to their values, and the spouse receiving Property A in the settlement must receive additional assets, if the division is to be equal.  And this relationship is irrespective of when the property owner decides to sell the property.



[1] A C corporation is a tax-paying entity.

[2] Land is not a depreciable asset.

[3] C corporations do not have a “capital gains” tax rate. All income resulting from a capital gain is taxed at ordinary corporate tax rates.

[4] Depreciation recapture is codified in Section 1250 of the Internal Revenue Code.

[5] Real estate is generally considered a “passive” activity, and any capital gain resulting from the sale of a passive activity investment is included in the definition of “net investment income” and subject to the 3.8% net investment income tax.

[6] Thirty years from now the property would be worth approximately $32.4 million ($10 million, @ 4% annual appreciation for 30 years).

[7] The decrease in the present value of taxes occurs because the assumed property appreciation, at 4%, is less than its assumed discount rate, at 8%. Different assumptions concerning future appreciation and investment risk can result in a materially different conclusion. Hence it is essential to carefully consider these factors.

[8] During the first 11 years the tax benefit from depreciating Property B totals $1.37 million (on a present value basis). Whereas the tax cost of selling Property B at the end of this same period is only $1.34 million (present value). Hence the net tax savings is $32 thousand and is shown in year 11 in the graph. After year 11, the graph illustrates a widening tax benefit due to depreciation.


Stephen J. Bravo is President and founder of Apogee Business Valuations, Inc.

Mr. Bravo appraises and advises closely-held businesses on valuation and tax matters and speaks and writes on valuation and tax issues.

Mr. Bravo is an Accredited Member of the American Society of Appraisers, Business Valuation, Accredited in Business Valuation with the AICPA and a Certified Business Appraiser with The Institute of Business Appraisers, Inc. Mr. Bravo is a Certified Public Accountant, a Certified Financial Planner (Institute of Certified Financial Planners), a Personal Financial Specialist (American Institute of Certified Public Accountants), and Notary Public. Mr. Bravo has a Master of Science in Taxation from Bentley College and his Bachelor of Science in Business Administration from Suffolk University.

Mr. Bravo is Charter member of the American Academy of Matrimonial Lawyers (AAML) Foundation’s Forensic & Business Valuation Division. He is a member of the Panel of Experts for the publication Financial Valuation and Litigation. He is a technical editor of Valuing a Business, Cost of Capital and many other valuation texts. For many years he was on the editorial boards of the American Society of Appraisers Business Valuation Review and the Institute of Business Appraisers Business Appraisal Practice.

Mr. Bravo can be reached at:

Apogee Business Valuations, Inc. 
904 Concord Street 
Framingham, Massachusetts 01701
Tel 508-872-6060
Sbravo@apogeebv.com
www.apogeebv.com

Stephen J. Bravo & Company 
904 Concord Street
Framingham, Massachusetts 01701
Tel 508-872-4002
sbravo@bravocpa.com