S Corporations: Real Estate’s Biggest Enemy (Behind Current Interest Rates)

While the majority of real estate assets are held in entities taxed as partnerships, it’s not uncommon to see closely held properties owned in S corporations. While these entities have their advantages, in the real estate industry, these tax structures create more unintended tax consequences than benefits. The disadvantages of S corporations include stringent ownership and allocation/distribution rules, loss and distribution limitations, issues getting property into the S corporation, inability to get the property out of the S corporation without triggering tax, limited ability to execute 1031 exchanges in situations when one or more parties want to cash out and no step-up in basis when there is a transfer of ownership or death of a partner.

Ownership, Allocations and Distributions:

• S corporations can only be owned by individuals and certain trusts, which severely limits ownership options for larger properties that are often owned by multiple tiers of partnerships.
• Allocations and distributions must be pro rata according to ownership.
  • No carried interests
  • Difficult recapitalization of distressed properties where preferred equity is often involved
  • No special allocations of depreciation deductions

Loss and Distribution Limitations:

• S corporation shareholders can only deduct losses to the extent of capital they’ve contributed or personal loans they’ve made to the S corporation.
  • Unlike partnerships, debt secured by the property does not give shareholders basis to deduct losses in excess of their capital contributed.
• S corporation shareholders that receive distributions in excess of basis have a capital gain on the distribution.
  • Unlike partnerships, owners’ allocable share of debt does not give them basis to take these distributions tax free.
  • Cash out refinances will often create an unexpected tax bill.

Getting Property In:

• It is not uncommon to see real estate that will be developed or redeveloped contributed to a partnership. When property is contributed to an S corporation, it’s a taxable event unless the person contributing the property owns at least 80% of the S corporation after the transfer, making these kinds of transactions nearly impossible.

Getting Property Out:

• Distributions of appreciated property from an S corporation is a deemed sale of the property, resulting in phantom income gain for the S corporation that is allocated to each shareholder based on ownership.
  • An S corporation that does not comply with the S corporation rules can have its status revoked by the IRS. If that S corporation is an LLC, the conversion back to a partnership is also a deemed sale.

1031 Exchanges

• S corporations cannot do drop and swap transactions when they have a shareholder that does not want to participate in a 1031 exchange for the reason mentioned in the previous section.
  • A drop and swap is often desired because each partner wants to do their own 1031 exchange. In these instances there is a workaround for S corporations, but careful planning and restructuring is required.

Basis Adjustments

• Partnerships allow for a step-up in basis of assets when there is a transfer of ownership or death of a partner. This rule does not exist for S corporations. Only the S corporation stock basis is adjusted in these scenarios, and the stock basis adjustment is not realized until the owner disposes of their stock.

For personalized guidance navigating the tax complexities of S corporations, contact Weaver for strategic support.

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