In some cases, the title to a property is held by a corporation. Should you buy the stock or buy the property from the corporation? There is no simple answer.
Holding property in a corporation has become very popular among real estate investors in the past few years. Not only does a corporation offer privacy and liability protection, but tax benefits as well. Syndications are also becoming more popular. For more information on syndications, read my post here.
Buy the Property or Buy the Stock? What is the Difference?
When purchasing a property you are buying an asset which upon closing, should be free of all liens and encumbrances. This is commonly referred to as a clear title.
On the other hand, when purchasing the shares of a corporation that owns the property, you are purchasing all the assets as well as all the liabilities. In essence, you are paying for the net equity of the corporation.
Why Would You Buy the Stock?
Depending on market circumstances and the condition of the corporation, it can sometimes be more profitable to buy the shares than it would be to just buy the property. This particularly true if you are purchasing a portfolio of properties. Let’s take a look at the pertinent factors.
If you have ever purchased a property, you are familiar with all the closing costs involved to close the deal. Some of these costs include title search, origination fees, and document stamps.
When you buy the stock of the corporation that holds title to the property, you avoid many of these costs. The title of the property does not change so there are no documentation stamps.
In addition, all mortgage financing remains in place so there are no appraisals or origination fees required. Sometimes the lender may impose a mortgage assumption fee if ownership of the corporation is changed but that fee will likely be significantly less than the fees associated with obtaining new financing.
Land Transfer Taxes
In some jurisdictions, a significant tax is imposed on the transfer of title of the land. This tax can be as high as 25% of the purchase price. This tax is added to your cost base which would reduce your ROI and cash on cash return.
Again, when you buy the stock of the corporation, the title to the property does not change so this tax is not triggered.
Net Operating Losses (NOL)
If the corporation has accumulated net operating losses over the previous years, when you purchase the share, you can carry forward those losses and apply them to future profits. In some cases, the depreciation expense can exceed the net cash income resulting in an accounting loss.
For a more detailed explanation of the tax treatment of NOLs, go here.
If you have purchased income property, you are aware that the assets of the property (excluding the land) can be depreciated. The depreciation taken reduces the book value of the property.
If the seller sells the property outright for an amount that is greater than the book value, the depreciation is “recaptured” and taxed as ordinary income.
For example, the seller purchased the property 10 years ago for $250,000. Over the following 10 year period, the property is depreciated by $20,000. The seller puts the property on the market and sells it for $350,000 resulting in a book profit of $100,000. However, $20,000 is depreciation that is recaptured and it would be taxed at the rate of ordinary income. The remaining $80,000 would be taxed as a capital gain.
If the seller has held the property for a long time and accumulated significant depreciation, it would be to his advantage to sell the stock in the company that holds the property. The seller avoids the recapture and only pays capital gains tax on the profit per share.
Conversely, if the accumulated depreciation is significant, it is to the disadvantage of the buyer. The depreciation expense declines over time so there may be little left to depreciate. Also, should the buyer decide to sell the property at a later date, he would incur the recapture and the associated tax liability.
However, if the NOL is significant, they could offset the loss of depreciation expense going forward by applying those NOL’s to future profits.
Debt to Equity Ratio
When making a real estate investment, you always want to use other people’s money. If the seller has owned the property for a significant length of time and property values have increased substantially, it would make more sense to buy the property instead of the shares and obtain new financing.
Conversely, if the seller recently acquired the property and it is still highly leveraged, purchasing the shares could be more attractive.
When you purchase a property, you should perform the essential due diligence, namely, search the title, investigate building permits, and inspect the property. Purchasing the shares of a corporation is a much more in-depth process.
Not only will you have to perform due diligence on the property itself, but you will likely have to hire an accounting firm to perform an audit on the corporation’s balance sheet. Depending on the size of the corporation and the length of time it has been in operation, this could be an expensive and time-consuming process but could be well worth the savings.
When Should You Buy the Stock?
Purchasing the shares of the corporation usually makes the most amount of sense when the market and/or the seller is distressed. Rents are declining and property values are dropping.
When property values are increasing, a seller can sell the property with little or no difficulty. However, if the market is distressed, the seller could be faced with additional costs. This is especially true if the seller has a portfolio loan.
What is a Portfolio Loan?
A portfolio loan is essentially a blanket mortgage on two or more properties. They are structured very differently from a traditional 30-year fixed mortgage.
One of the more common features of a portfolio loan is that a minimum debt to value ratio has to be maintained. For example, the total debt cannot exceed 80% of the value of the underlying properties.
In the event that property values begin to fall, the lender has the right to demand a capital call whereby the owner would have to pay down the mortgage to bring the ratio back under 80%. Should the owner have insufficient reserves and is unable to make the required payment, the lender has the right to foreclose. The lenders prefer not to exercise this option as they are not in the business of managing properties.
Renegotiating the Portfolio Loan
If you have the option to purchase the shares of the corporation, you are in a position to renegotiate the terms of the portfolio loan. For example, the interest rate on the portfolio loan is currently 6%. However, current market rents can only support a 2% interest rate. You could ask the bank to lower the interest rate to 2% for a period of 5 years in order to make the deal viable. Hopefully, the market will recover before the interest rate adjustment period expires.
The lender is likely to agree to that adjustment. If they are forced to foreclose, they would have to write off the loan and sell each property on a piecemeal basis. This would be a costly and time-consuming process for the lender.
The Bottom Line
Buying the stock in a corporation usually only makes sense when buying high-value commercial property or a portfolio of properties that are held under one corporation. The only exception is high-value homes that are located in a jurisdiction with significant land transfer taxes.
The due diligence costs for a low-value property is just not worth the time or expense.
Buying the stock is particularly attractive when the market is distressed and when lenders have curtailed mortgage funding.
Do not attempt to do this kind of deal on your own. You will require the services of an experienced corporate attorney and a financial accountant.
The information provided here is for educational purposes only and is not to be construed as professional legal, tax, or financial advice. Every situation is unique and you should consult with an attorney, tax accountant, or financial adviser to determine the best options for your particular situation.