United States: Tax Considerations In Real Estate Dispositions

In a typical real estate transaction, the seller deeds the real property to the buyer. This transaction is simple and straightforward for both buyer and seller. Although it is simple, is it the best structure from a tax perspective? Many times, the answer is no.

Most sophisticated real estate sellers already hold their real estate through separate entities such as limited liability companies, partnerships, real estate investment trusts and corporations. Generally, each entity holds one property, thereby isolating liabilities associated with that property to prevent them from jeopardizing the success of another property. This ownership structure often provides the parties with an excellent opportunity for tax savings if they are willing and able to structure the transaction as a sale of the entity owning the real property, rather than a sale of the real property. The tax savings, while usually to the benefit of the seller, can benefit the buyer as well if the seller is willing to make an adjustment to the purchase price.

When discussing the tax benefits of an entity sale, the most common tax benefit is a transfer tax savings. When real property is transferred by deed, the deed is typically subject to tax by the local jurisdiction when it's recorded. These transfer taxes can quickly add up to a sizeable tax bill for the seller. In Florida and many other jurisdictions, these transfer taxes can be avoided by having the seller transfer its interest in the entity that holds the real property instead of the deed. When dealing with valuable parcels of real estate, these transfer tax savings can be substantial. It should be noted that, depending on the jurisdiction, it may or may not be possible to put an effective structure into place to reduce the tax hit prior to a sale, if the property is not already in a structure that would work as an entity sale. A growing number of jurisdictions are implementing rules that would make the entity sale subject to a transfer tax in that situation. For example, Florida, with certain exceptions, imposes transfer taxes on transfers of interests in entities that hold real property if such entities acquired the real property less than three years before the entity transfer and no transfer tax was paid at that time.

Another situation where an entity sale can result in significant tax savings involves sales that would otherwise be subject to tax under the Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA"). FIRPTA provides that foreign sellers are subject to tax in the United States when they sell or dispose of a U.S. real property interest. To ensure that the tax is paid, FIRPTA requires the buyer to withhold ten percent of the amount realized on the sale. This withholding is on the total amount of the sale, not the actual tax profit recognized by the seller. This withholding can obviously be a significant burden for foreign sellers. As a result, many foreign sellers want to structure their real estate sales to avoid FIRPTA withholding if possible. Unfortunately, an entity sale does not typically avoid FIRPTA. A special exception to FIRPTA exists, if the entity being sold is a domestically controlled real estate investment trust. Many foreign investors will structure their holdings in U.S. real property to take advantage of this FIRPTA exception and will hold their real property through domestically controlled real estate investment trusts. When it comes time to liquidate their investment, these foreign sellers will often insist that the sale be structured as a sale of the real estate investment trust, and will refuse to do the deal in any other form.

While the tax savings discussed above may motivate the seller to structure a real estate transaction as an entity sale, a buyer needs to understand fully the special risks associated with an entity acquisition. By acquiring the entity, the buyer will take on all of the liabilities associated with that entity. These include the types of liabilities with which many buyers are familiar, such as environmental and premises liabilities; as well as liabilities with which buyers may be less familiar, such as income and sales tax liabilities for periods during which the seller owned the entity. The extent of the income tax liability exposure will depend on how the entity is taxed for federal income tax purposes. While partnerships and S corporations are typically less problematic, C corporations and real estate investment trusts can involve significant tax liability exposure. This is particularly true for real estate investment trusts. For this reason, an entity sale will require the buyer to do more extensive due diligence, and the due diligence cannot be limited to the real property. The buyer will also need to perform a due diligence review of the business and tax records of the entity. Many buyers mistakenly believe that they can minimize the tax risk by liquidating the entity immediately after the acquisition. In the case of corporations and real estate investment trusts, this is not only untrue, but the tax risk may increase. The Internal Revenue Service generally has a three year statute of limitations in which it can audit and assess corporations and real estate investment trusts for tax liabilities. However, if the entity is liquidated, the Internal Revenue Service has an additional year added to the statute of limitations to go after the entity's successors (i.e., the shareholders or owners) for the tax liability.

An entity acquisition may also result in a higher future tax cost for the buyer. If the entity is disregarded or taxed as a partnership for federal income tax purposes, the buyer generally is able to step up the entity's basis in the real property to increase the purchase price paid by the buyer for the entity. For other types of entities, though, the buyer may have a basis in the entity equal to what it paid for the entity, but the entity itself will generally not be able to step up its basis in the real property. This can result in additional tax cost for the buyer after the acquisition if it dissolves the entity or sells the real property.

While the preceding discussion identifies risks that a buyer should consider and evaluate before acquiring the interest in an entity holding real property rather than acquiring a direct interest in the real property, the business risks may be sufficiently offset when the tax savings of the entity acquisition are substantial. Once the buyer identifies and understands the risks, it can protect against and/or minimize them with a properly drafted purchase and sale agreement. If the tax savings are big enough, both the buyer and seller will have a significant incentive to work together and reach an agreement that benefits both of them.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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