Commercial Real Estate Financing and Subchapter S Corporations

One night in the early 1970's a burglar was climbing on the roof of a rental property in New York.  Suddenly the roof gave away, and the burglar fell two stories, sustaining significant injuries.

The permanently-injured burglar sued the property owner, and to everyone's surprise and horror, the jury awarded him millions of dollars in damages.  The property owner was held to be negligent for allowing the roof to be in a state of such disrepair.

The property owner was ruined.  He owned the property personally, in order to shelter his earned income with passive real estate losses.  Because he owned the property personally, the burglar-plaintiff could attach the owner's personal assets.

After word of this case reached the investing public, tens of thousands of commercial property owners transferred ownership of their commercial properties to single-asset Subchapter S corporations.  A single asset entity is a corporation or limited liability company that owns only one asset, usually a commercial property.  The idea here is that if the company loses a personal injury lawsuit, the plaintiff can only seize the single asset and not all of the assets of the owner.

For years this property-holding strategy worked wonderfully.  The difference between a Subchapter S corporation and a plain-vanilla C-corporation is that the  net income or losses of the Subchapter S corporation are not taxed at the corporate level.  Instead the net income or losses pass directly through to the personal tax returns of the shareholders, according to their percentage of ownership.  

Do you remember the example of Bob's Trucking, Inc. from our earlier article about plain vanilla C-corps?  You will recall that Bob's Trucking, Inc. earned $1 million in profits and paid $310,000 in corporate income taxes.  Then the poor shareholders had to pay another $300,000 in personal income taxes when the remaining $690,000 in profits were distributed as dividends.  Now if Bob's Trucking had been an Subchapter S corporation, the entire $1 million in profits would have passed through the corporation untaxed to the personal tax returns of the shareholders.  This is the huge advantage of an S-corp versus a C-corp.  Of course the shareholders of the S-corporation would have been required to pay personal income taxes on the $1 million in profits - but they wouldn't be required to pay taxes twice.

In 1986 the tax laws were changed, making it impossible for the shareholders to shelter earned income (salary, other business profits) with passive real estate losses (depreciation).  After 1986 Subchapter S corporations have seldom been used to own commercial properties.

Should a lender or mortgage banker ever run into a situation where they are refinancing a property owned in a Subchapter S corporation, they should treat it just like any other corporation.

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