This update is meant to provide U.S. investors in real estate with information regarding a federal tax election that may ease the federal income tax burden of income created by debt forgiveness, including any reductions in debt where certain types of businesses become insolvent. With the uncertainty created by the COVID-19 pandemic, U.S. real estate investors should be wary of highly leveraged asset owning companies potentially creating significant amounts of taxable income.
Most U.S. investors in real estate will have invested through a company that is treated as a partnership or disregarded entity (“DRE”) for federal tax purposes. A partnership or DRE can have many advantages for ownership of real estate. However, one disadvantage is when a partnership or DRE has a loan forgiven in part or in whole, oftentimes the individual partners or DRE owner has to recognize the forgiveness amount, or at least some part thereof, as income.
Companies that qualify for what are known as S corporations, on the other hand, are tested for insolvency at the company level. Thus, if an S corporation is insolvent, it will be eligible to exclude debt forgiveness income up to the amount by which it is insolvent. This, in effect, would mean that the company’s owners would not have to recognize such debt forgiveness as income.
U.S. investors will be relieved to know that it is possible to make an election for federal tax purposes that would treat a partnership or DRE as an S corporation if the company would otherwise meet the S Corporation requirements. The typical eligibility requirements for an S corporation are that the company must:
a. have fewer than 100 shareholders;
b. have only one class of stock (voting and non-voting stock can be held within the same class);
c. be a domestic entity; and
d. have only allowable shareholders, which include U.S. individuals, certain trusts, and estates, but not non-resident aliens, partnerships, or corporations.
Under the right set of circumstances, the S corporation election could be made retroactively up to 3 years and 75 days.
Although there are significant advantages to holding real estate in partnership or DRE form, the income created by debt forgiveness may significantly outweigh any such advantages. Depending on the circumstances, by properly making use of the S corporation election, real estate and other U.S. investors in highly leveraged assets may be able to avoid significant tax burdens created by the recognition of debt forgiveness income.