C Corporation Planning May Avoid Imputed Income From Mortgage Debt Forgiveness

Often, the biggest problem with mortgage deficiency actions related to foreclosed investment property is the possibility of imputed income from debt forgiveness. Even if the mortgage lender does not pursue collection of a deficiency judgment, or if the lender settles with the mortgagor for partial payment of the total deficiency, the lender is likely to send a 1099 tax form to the mortgagor in the amount of uncollected or forgiven debt.

One of my clients explained how he plans to avoid the income tax associated with imputed debt from a defaulted mortgage on a commercial property. This client, like most real estate investors, set up a LLC to hold title to the property and elected to have the LLC taxed as an S corporation. The LLC provides a “corporate shield” from lawsuits involving the property, and the S election permits the owner to flow through depreciation and other tax losses.

The LLC is the borrower and mortgagor in this case. My client said his CPA told him that the mortgage lender likely would issue the 1099 tax form to the LLC so that the LLC would recognized imputed income for debt forgiven. The client’s problem is that since the LLC is taxed as an S corporation the LLC’s imputed income would flow through to the client on Schedule E of his personal return.

The CPA told the client he could avoid personal taxation on the imputed income if the LLC were taxed as a C corporation instead of an S. This is because in the case of a C corporation all taxation is recognized at the corporate level and the income or losses do not flow through to the owners. So, if the mortgage company issued to the client’s LLC when the LLC was a C corporation the 1099 imputed income would stay at the C corporation level and not impact the client’s 1040.

S corporations have strict ownership rules. For instance, an S corporation must be owned wholly by natural persons as opposed to trusts, partnerships etc, and S corporations cannot have foreign owners. If and when any one shareholder is an ineligible owner then the S election is forfeited and the entity reverts to a C corporation. The client’s CPA suggested that the client assign some LLC interest to an irrevocable trust for his children. The irrevocable trust is not an eligible S corp owner so that the assignment will cause the LLC to revert to a C corporation. Then, when the lender issues the debt forgiveness the tax effect will stop at the LLC level. Essentially, the CPA recommenced to the client that he intentionally forfeit the S election to avoid the tax from the mortgage debt forgiveness.

I find this plan a creative solution for a common tax problem faced by real estate investors, but not being a tax attorney, I have no opinion whether this plan will work. If it does work, I question whether the plan would be successful where an individual owner personally guaranteed or co-signed the mortgage with the S corporation / LLC borrower. My question is whether the LLC and individual co-signers and guarantors are jointly liable for imputed income from deficiency forgiveness.

Last updated on May 22, 2020