Management of real estate from a tax perspective

If such real estate is primarily intended to provide for old age and is to be passed on to the next generation at a later date for emotional reasons, among other things, then the question regularly arises as to whether it would be better from a tax point of view to "manage" this real estate via a "management company" in the form of a stock corporation or a limited liability company, or whether the management of the real estate should continue to be carried out privately.

This blog post uses a fictitious case study from the canton of Lucerne to illustrate the tax options and, in particular, the pitfalls that must be taken into account in these considerations.

Case study

Facts

A. is 45 years old, divorced and father of two children. A. lives in the city of Sursee in the canton of Lucerne. Recently, A. inherited two apartment buildings (MFH) in Sursee from his father. The asset value of the MFH amounts to CHF 10 million, the investment costs amount to CHF 6 million, and the properties are subject to mortgages of CHF 4 million, which are subject to a fixed interest rate of 1.5%. The MFH generate annual rental income of CHF 350,000, the costs for the maintenance of the properties (incl. external administration) amount to CHF 75,000.

A. works part-time in the IT sector, his net annual salary amounts to CHF 100,000. In addition, he receives annual income from securities in the amount of approximately CHF 20,000. The income tax deductions amount to an average of CHF 15,000.

A. sees the apamennt buildings as part of his retirement provision. He would like to bequeath the apartment buildings to his two children later.

Question

Based on these facts, the question arises whether it can be worthwhile for A. to transfer the apartment buildings and thus also its management to a corporation (i.e. to the entrepreneurial sphere)?

Transfer strategy

When transferring real estate to a corporation, it is important to take into account the respective cantonal differences, which can be considerable in Switzerland, especially with regard to real estate gains taxes.

In the Canton of Lucerne, real estate held as private property within the meaning of Section 17 (3) of the Real Estate Profit Tax Act of the Canton of Lucerne may be sold to a legal entity subject to profit tax at a lower value than its market value. In concrete terms, this means that the purchase price can be freely determined by the contracting parties, provided that it is between the investment costs and the market value of the real estate. The basis for the assessment of the real estate gains tax is the value at which the real estate is recognized in the balance sheet of the legal entity at the time of acquisition.

If a property is sold to a legal entity below its fair market value, the tax authorities levy a so-called subsequent tax reservation within the scope of the assessment of the real estate gains tax. In the event of a later realization of the real estate gain (in particular through resale of the real estate by the corporation) within five years, the tax authorities reserve the right to subsequently tax the difference between the investment costs and the market value at the time of the sale to the legal entity, which has not yet been assessed with the real estate gains tax. The reservation is due in particular to the fact that in the Canton of Lucerne, under the so-called dualistic system, real estate gains tax is only levied on sales from private assets, while sales by legal entities are always subject to tax only at CIT . The tax authorities are not obliged to levy real estate gains tax on sales from private assets.

If a transfer from a real estate to a self-held company at the investment cost is planned, it is advisable to obtain a tax ruling from the competent tax authority regarding the amount of the investment cost and the fair market value of the real estate.

In the present case, A. has no interest in paying real estate gains tax immediately at the time of the transfer on the difference between the investment costs and the market value. With a presumed gain of CHF 4 million in this case, the tax burden would also be considerable and could probably only be paid with an increase in the mortgages. In this respect, A. will use the tax advantage in the Canton of Lucerne and transfer the apartment buildings he inherited at the investment cost of CHF 6 million to the new corporation to be established. In this respect, A. is only interested in the question of how high the current tax burden will be per year and whether this tax burden can be optimized.

When planning the transfer, however, it is not only the optimization of the real estate gains tax that must be taken into account. When transferring the properties, additional transfer costs will be incurred which, depending on the value of the properties, can have a significant impact. These transfer costs include the property transfer tax (in our case, the Canton of Lucerne levies a one-time property transfer tax of 1.5% of the cadastral value of the properties) and also the notary and land registry fees, since the transfer must take place by means of a "purchase agreement" with a change of ownership in the land register.

Determination of current taxes

The transfer of the real estate to a corporation at the investment costs of CHF 6 million has no real estate profit tax consequences for A.. In addition, the acquiring corporation can form so-called capital contribution reserves to the extent of the difference between the mortgages and the investment costs of CHF 2 million, which can be returned to A. by the corporation free of set-off and income tax. The capital contribution reserves are subject to cantonal capital taxes at the level of the corporation.

By transferring the real estate into a corporation, A. has various possibilities to plan his tax burden in a long-term and targeted manner. A. would not have these possibilities if he only held the apartment buildings as private assets. Because the apartment buildings are held by a corporation, for example, depreciation can be taken (1.5% to 2.0%, depending on the accounting), the CIT can be deducted for profit tax purposes and provisions can be made for so-called major renovations.

In addition, A. can retain the profits resulting from the management of the real estate in the corporation (i.e. not distribute them annually as dividends), as well as have a portion of the funds generated repatriated from capital contribution reserves free of offsetting and income tax. This would in turn allow A. to achieve additional tax deferral.

Taking into account the assumptions in the facts, an annual full distribution of the profit from the management of the apartment buildings results in an approximate total tax burden for A. (i.e. including the CIT of the corporation) of around CHF 61,500. It should be noted that A. can "control" the tax burden himself in particular by, for example, not distributing all profits as dividends or by distributing part of the dividend from capital contribution reserves.

In the case of a self-owned corporation, the question always arises as to whether part of the profit qualifies as a salary or whether A. would have to pay out part of the profits to himself as a salary, since as the owner of the corporation he will presumably also be the managing director. Although the salary would be fully deductible at the level of the corporation, A. would have to pay full tax on it (no partial taxation as in the case of dividends) and, in addition, old age and disability pension contributions would have to be paid on it. In this respect, it is advisable to proactively discuss the issue with the competent social security authorities in a case such as this to avoid unpleasant surprises in the future.

Comparison: Management of real estate from private assets

In the variant where A. continues to hold the MFH as private assets, the tax situation is considerably different. The income from the management or administration of the real estate is always recognized for income tax purposes in the same year as the income is generated. In this respect, taxation cannot be postponed. On the other hand, taxes are only levied at one level, so there is no CIT to pay. An additional advantage, which arises in the case of private property management, is the possibility to choose each year between the general lump-sum deduction for the maintenance of the real estate and the actual costs incurred, depending on which amount is higher. A corporation does not have this possibility.

Taking into account the assumptions according to the facts of the case (i.e. in particular A.'s other income, which is decisive for the determination of the applicable income tax rate), the total tax burden for A. from the management of the apartment buildings amounts to approximately CHF 67,000.

Conclusion

If the two variants are compared, it can be seen that the two variants for handling the management of real estate are comparable from a tax point of view. It is not clear which variant is more optimal from a tax point of view, especially if the risk of income under social security law is taken into account in the variant with the transfer to a corporation.

However, the variant with the transfer of the apartment buildings into a corporation has the clear advantage that the tax burden can be planned for the long term and thus optimized. In addition, the transfer to a corporation can facilitate the transfer of the real estate to the next generation.

It should again be noted that the present assessment is tailored to the conditions in the Canton of Lucerne (incl. the applicable tax rates) and that, in the event of a transfer of the real estate to a corporation, notarial and land registry fees as well as transfer of ownership costs are also incurred on a one-off basis, which would not be incurred in the case of private management. The result can therefore differ from canton to canton or even from municipality to municipality, especially if the real estate is not located in the same canton or municipality as the taxpayer as the owner of the real estate.