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Planning for Real Estate in C Corporations Amidst COVID-19

Over the last several weeks, we have witnessed major cities go into lockdown, businesses close, and people learn to interact with each other under a “new normal".

As COVID-19 has been leading the U.S. economy towards a downward spiral and forcing millions of Americans out of jobs, it is still early to predict how the real estate market will behave in the upcoming months.

What Impact will COVID-19 have on the Value of Real Estate?

As stock markets have been heavily impacted by the pandemic, the real estate market on the other hand has not had the same instant reaction. Since the onset of the pandemic, mortgage rates have fluctuated and the unemployment rate has skyrocketed. Many landlords and tenants are communicating more than they ever have to determine how to get through this crisis with the intention of keeping as much real estate “active” and “alive” as possible. In reality, real estate values tend to decrease during an economic recession, to which most indicators are pointing.  However, areas in high demand may not see values of their property decrease. With mortgage rates so low, prospective buyers may want to capitalize on the opportunity to invest.

Is Now a Good Time to Restructure a C Corporation?

With the uncertainty of the market, now might be a good time to think about restructuring if real estate is held in a C Corporation. Most likely, there are some old C Corporations that have appreciated real estate that have not moved their assets. Normally, C Corporations become advantageous when the business is making profits and keeping the earnings within the company for many years down the road. However, with the uncertainly ahead, flexibility may be key. When investing in real estate, the goals are long term future appreciation and current cash flow. A C Corporation is not a pass-through entity, therefore, taxable income is initially taxed at the entity level. When assets held inside a corporation appreciate and are sold by the corporation at a higher value, the gain is then taxed at corporate income tax rates. Subsequently, when the net profits are distributed, the shareholders must also report the dividend income, which is then subject to a second level of tax at the individual level. To avoid the double taxation, restructuring the business may be a valid consideration, among other options. The best tax solution will vary for each individual situation.

For more information on this topic, please contact a member of the Real Estate Services Group.
  • Conversion to S Corporation
    A potential solution to avoid the double taxation on the liquidation of real estate in a C Corporation, while still maintaining the liability protection, is to convert to an S Corporation. An S Corporation can sell appreciated real estate and generally not owe tax on the sale and, instead, the gain is passed through to the shareholders. However, the S Corporation must hold the appreciated assets for a minimum of five years after converting from C Corporation status. If not, there are possible tax implications.

    • Built-In Gains Tax: If the appreciated assets are sold within the first five years, the S Corporation would be subject to built-in gains tax, whereby built-in gains are taxed at the current rate of 21% on the appreciation that existed at the time an S conversion was made.
    • Excess Net Passive Income Tax: When an S Corporation has accumulated earnings and profits, the income generated from interest, dividends, rents, and royalties could be subject to an additional excess net passive income tax. The excess net passive income tax is generated when passive income exceeds more than 25% of the S Corporation’s gross receipts.
  • Distributing Real Estate
    With the uncertainty of today’s market, property owners may want to consider transferring real estate out of a C Corporation as mentioned previously. As the market declines, it’s possible there will be a drop in real estate values as well, which can give taxpayers an opportunity to transfer real estate that may have lost value out of a C Corporation when values are low, relative to past years. When distributing real estate out of a C Corporation there are a few tax consequences to consider:

    • Fair market value exceeds adjusted cost basis: Under this scenario, a corporation will recognize gain, since the distribution of property is treated as a sale of property. The shareholder will then report a dividend to the extent of the corporation’s E&P (Earnings and Profits). If a distribution is greater than the corporation’s E&P, the excess is treated as a nontaxable return of capital to the extent of the shareholder’s basis.
    • Fair market value lower than adjusted cost basis: Under this scenario, a corporation cannot recognize a loss on distribution of property. The shareholder will record a dividend to the extent of the corporation’s E&P. If a distribution is greater than the corporation’s E&P, the excess is treated as a nontaxable return of capital to the extent of the shareholder’s basis.
  • Selling Real Estate
    A sale of real estate may be a viable method of generating much-needed cash during the current financial crisis. It’s important to assess the potential tax implications of doing so to ensure maximum cash inflow.

What’s Next?

Business owners are using more caution as they anticipate what the near future will bring.  This has been an unparalleled time for everyone as companies look into the future to assess, plan and implement to travel the road ahead.

Author: Kellianne Seibert | kseibert@withum.com

Real Estate Services

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