Top Five Considerations to Make When Purchasing Corporations that Hold Real Estate​

Our team has recently been assigned the task of selling 100% of the shares of an S corporation which holds real estate assets. This opportunity brought up a challenge in assessing the benefits and risks of holding real estate in a corporation as opposed to an LLC or a sole proprietorship, and the tax implications for this transaction.

The motivation for the seller of this corporation is that they inherited their real estate portfolio in a C-corp, and after assessing that situation, elected to convert the C- Corp to an S- Corp. They then faced the issue of selling the assets individually or in bulk, and based on the advice of their legal and tax counselors, elected to opt to sell the S Corp outright.

Advantages and Disadvantages of C-Corporations

Holding real estate in a corporation has various advantages. A C-Corp is a taxable entity, where the corporation itself is taxed on its income (as opposed to other structures which simply pass income along which is subsequently taxed). For those that do not necessarily need to pull all of the net income out of their corporation, the C-Corp provides for keeping cash in the entity. It also provides the benefit of income splitting, where the business’s income is split so that part of it is taxable to the corporation and part of it is taxable to the owners of the corporation. However, C Corp taxation is such that distributions are subject to double taxation, where the corporation is taxed on its income, and the shareholders are taxed on the dividends received.

The Tax Cut And Jobs Act has invoked recent changes to the US tax code, and has reduced the corporate tax rate from 35% to 21% thereby reducing the deductibility of state and local income tax payments in determining federal income. Now that this code has passed into law, the advantages for some Real Estate Investment Trusts (REITs) to convert to C-Corps is starting to have “legs.” Most times, this involves a simple measure of becoming a Real Estate Operating Corporation, or REOC. What this means is that REITs, which ordinarily must distribute 90% of their net income as dividends, may find it advantageous to de-REIT and become a C-Corp. REITs that would benefit from this change would be those that have assets that have lease up/rollover risk, require capital expenditures, and/or need to be redeveloped.

The REIT structure in this instance puts the company at the mercy of the market, and requires the sale of assets to to raise capital. REOCs benefit from this structure as they can self-finance their expansion, and can retain capital and reinvest it in a more tax-efficient way, and in a manner that is consistent with the nature of real estate.

REITs that do not need this structure are those that own triple-net assets, self-storage and, in some cases, health care properties. REITs that would benefit from C-Corp conversion would be those that own malls, large shopping centers with redevelopment needs, and office properties.

S-Corporations Versus LLC Ownership

The S-Corp holding manner has some tax savings as profits from the S-Corp are not subject to self-employment tax. However, the S-Corp still must pay any owner-employee a reasonable salary which is subject to Social Security and Medicare taxes. S-Corps are significantly more complicated than LLCs and require more professional input, meaning billable hours for accountants and attorneys.

Ownership as an LLC has no tax advantages or disadvantages. In California, LLCs are subject to franchise taxes in addition to typical income taxes. LLCs, particularly single-purpose LLCs, are also the preferred method of ownership for lenders, and in some cases absolutely required.

Purchasing a Corporation

In purchasing a corporation for the purpose of controlling the underlying real estate assets, one must understand that this transaction differs significantly from a straight real estate transaction in many ways; namely, taxes, financing, and ultimately, value.

  1.  The purchase of the corporation does not qualify for a tax deferred exchange. Trade dollars can be used, but the purchase would not qualify for a 1031 tax deferred exchange. This does not affect value directly, but limits the utility of the transaction for the buyer.
  2.  The sale is, in effect, a change of control, which may trigger issues with loan covenants (if there is debt on the portfolio) and in California, reassessment of real estate property taxes.
  3. The purchase of the corporation can be financed as a corporation purchase which may or may not have the same metrics as financing for straight real estate purchases. Overall loan dollars will be affected by the valuation of the corporation itself, which may or may not follow the underlying real estate assets. Some lenders may only offer credit lines for these transactions, and some lenders limit the loan dollars to a lower loan-to-value ration on the purchase. However, some lenders offer more dollars on a refinance, so structuring a transaction with bridge financing to be taken out as a refinance later may be beneficial in this instance.
  4. The basis by which capital gains are computed does not change in the sale of the holding corporation. This means that there is no “step up” in basis, and the original basis follows. Also, depreciation is inherited as well, and does not re-set. This must be properly reviewed by one’s tax and legal professionals.
  5. The acquisition of the corporation will put you in the place of the former principals, including responsibility for liabilities. One must fully explore the potential liabilities that might be inherited. If the corporation has been carrying “per occurrence” insurance, that insurance is supposed to cover claims made in the future for anything alleged from the past. This should be carefully reviewed with the insurance carrier during due diligence, as well as legal counsel. Also, full due diligence on all prior activities should be done, and as an additional measure of safety, an umbrella liability policy might be in order. This is the stuff that makes careers for insurance and legal professionals, and definitely consult both to fully understand the issues.

Purchasing a corporation has benefits and risks. Carefully explore both before launching into the venture. Please also feel free to reach out to a team member to discuss further.

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