In August of 2012, Taylor Swift released her fourth studio album, “Red.” The lead single on the album “We are Never Ever Getting Back Together” was about never renewing her relationship with her former boyfriend, rumored to be Jake Gyllenhaal. Seldom in life do we adopt absolutes such as “Never Ever.” There always seem to be exceptions to the rule.

There are few, if any absolutes, in business or in tax law. Especially in tax law, where at times it seems like even the exceptions have exceptions. Nevertheless, I would suggest that there is one absolute rule when it comes to owning and operating assets within business entities and that is “Never Ever put Real Estate inside of an entity that is taxed like Corporation.”

Why? Real estate is an asset that rarely goes down in value. Decaying buildings and neighborhoods and environmental concerns may cause real estate to decrease in value from time to time, but generally real estate holds its value and appreciates in value.

The owners of rental real estate are frequently concerned about potential liability due to injuries that could occur on the property. Many of these risks can be covered via property and casualty insurance, but if the damages exceed the value of the property and the policy limits, then other assets of the property owner may be at risk. As a result, it is common for property owners to hold the title to real estate in the name of an entity that will shield the owners and their other assets from legal exposure.

In business school, we are taught that corporations, limited partnerships, and limited liability companies all provide some level of asset protection (“a shield from liability”). If assets are owned inside of the entity and certain formalities are followed which respect the entity as the legal owner (e.g., keeping separate books and records, minutes of meetings, not commingling assets with personal assets), the entity will shield the assets held outside of the entity from exposure. While all three entities can provide similar asset protection, they do not share common income tax or estate tax benefits.

The income tax law permits appreciated assets, being transferred into and out entities that are taxed under partnership rules, to avoid income tax on the difference between the asset’s fair market value and its income tax basis. On the other hand, assets that are held inside of entities that are taxed like corporations (whether they are taxed under SubChapter C or SubChapter S of the Internal Revenue Code) will trigger income tax on the distribution of appreciated assets out of the corporation. The assets are frequently “stuck” inside the corporation, because shareholders are reluctant to pay the tax necessary to liquidate the entity.

The estate and income tax laws, working in combination, permit assets that are included in the potential taxable estate of a decedent to get a basis “fresh start”. The basis of these capital assets may be stepped-up to fair market value at date of death. The partnership rules permit the entity to elect to transfer this stepped-up basis to the assets held inside of entities that taxed like partnerships. The corporation income tax rules do not permit the same election to be made for assets held inside of entities that are taxed like corporations. As a result, the assets held inside of an entity taxed like a partnership have the potential of saving income tax by being depreciated as second time, whereas the assets held inside of the corporation retain their low basis.

The decision to purchase real estate inside of a corporation is often based on non-tax factors. For example, the cash to purchase the asset or the availability of the credit to finance the purchase might be inside of the corporation. As a result, it is easier to buy the appreciating asset inside of the corporation rather than pursue other financing options.

Easy is convenient, but it has a price, like getting back together with an old boyfriend or girlfriend, it’s a bad idea. So, remember the Taylor Swift Rule, when it comes to real estate “Never ever … ever, buy real estate inside of an entity that is taxed like a corporation”.