Real estate that is purchased as an investment property should always be kept separate from your personal assets. Holding properties in your individual name, whether that’s a rental home or a flip property, can result in legal risks and personal financial liabilities. U.S. tax law allows investors to protect their personal assets by creating a separation in the form of a single-member LLC if you own the property by yourself, a partnership or multimember LLC if you own the property with others, or even a corporation, which are all used to insulate debts and obligations of those properties from the owner’s personal assets.
The choice of entity for any business is critical because there are restrictions at the federal and state level and pros and cons for each structure. When choosing your entity type, you must consider the legal, financial, and operational implications. The dos and don’ts are important to understand to ensure you stay in compliance and avoid potential issues related to your entity not operating properly. The business owner(s) have a very important decision when choosing an entity structure because it will affect the entity and themselves as the owners, shareholder, partner, or member. As a business that owns or plans to own real estate, there are even more factors to consider.
The allure of the S-Corporation is the avoidance of double-taxation. A “regular” Corporation (or C-Corp) pays tax on its profits at the business level, and then when the owners take those profits out of the business, it’s treated as a dividend and taxed on the owner’s personal income tax return. Yuck! So as an aside unless you’re planning on bringing on more than 100 owners or you’re very concerned with protecting your personal assets, you shouldn’t need to consider a C-Corporation.
Not only are S-Corporations allowed to avoid a corporate tax and instead pass through the income, and therefore the tax, to the individual owners. But S-Corporations profits are NOT subject to that nasty 15.3% Social Security and Medicare (also called Self-Employment) Tax. Now you understand how tax beneficial the S-Corporation can be for highly profitable businesses.
Here is where I drop the hammer and tell you why an S-Corporation isn’t a good place for your real estate:
- S-Corporations only have one class of stock and a very limited number and type of shareholders. S-Corporations cannot have more than 100 owners, and they need to be U.S. citizens or resident aliens, grantor/living trusts, estates, or non-profit entities. Owners of S-Corporations cannot be Corporations, Partnerships, business trusts, or IRAs.
- Contribution of property, sales or liquidation of shareholder interest in the S-Corp, and distributions of profits from S-Corporations all trigger taxable events. Contributions of appreciated property into an S-Corporation are subject to tax when the shareholder owns less than 80% of the corporation’s majority vote, and value after the transfer occurs. When S-Corporations distribute profits to shareholders, and when shareholders sell their stock, taxable events also occur.
- Depending on the level of involvement in the entity, certain shareholders may not qualify to deduct S-Corporation losses from other income sources. The entire point of the S-Corp is to generate significant profits so that your S-Corp profits can avoid that self-employment tax. But the first few years might be slow going, and you might show a loss in the business. Section 469 of the Internal Revenue Code states that taxpayers who do not “materially participate” in an income-generating activity regularly and continuously may not use the losses from those passive activities to reduce non-passive income earned from wages, interest, dividends and capital gains. So if you do not participate in managing the property, collecting rent, paying bills, keeping the books, if you have a management company doing that for you, or if you are working on other areas of the business, you cannot reduce your other income by the loss from the rental. That loss can only be used to reduce future income from the rental.
- S-Corporation assets do not receive a step-up in tax basis upon the death of a shareholder. When the shareholder of an S-Corporation passes away or sells their interest to third parties, the beneficiaries (or buyers in a sale) receive a “step-up” in the basis of their inherited (or purchased) S-Corporation stock to the fair market value at the time of death (or sale). A Step-Up means that the asset is reassigned a value based on the fair market value at the time of death. This treatment helps reduce or even eliminates any capital gains taxes owed by the new owners in the future. The issue with real estate is that the step-up does not apply to any of the S-Corporation’s assets. This is a huge negative of having S-Corps hold your real estate, especially if the plan is to hold onto the rentals long-term and eventually pass them down. Partnerships or LLCs have to file Section 754 electing to step-up their assets to the fair market value, and they are able to take advantage of the step-up in basis treatment. As an example of how impactful this can be. Let’s say you purchase a property for $200,000, and when you pass away, it’s worth $500,000. If the property is held in an LLC or partnership, the beneficiaries receive the asset at a cost basis of $500,000 (the new “stepped-up” fair market value). If that property is held in an S-Corporation, the beneficiaries receive the asset at a cost basis of $200,000. So if they sell it one year later for $600,000, that’s a difference in a tax gain of $100,000 vs. $400,000.
- If you fail to comply with the requirements of being an S-Corporation, which requires the business to hold both initial and annual director and shareholder meetings, adopt and maintain bylaws, issue stock to all shareholders, and record any stock transfers, you can have your S-Corporation status revoked. Once the IRS takes away your S-Corp tax treatment, you are, by default, a C-Corporation. And now you have all of the same problems as an S-Corporation, AND you’re double taxed.
Business ownership is complicated; it’s hard. And as you can see, there are short-term benefits of certain structures and entity setups, but those often come with potential long-term effects that you likely won’t be able to undo. For decisions like this, you should always discuss with a tax attorney who specializes in real estate and can offer advice based on what they see what others are doing and what works and what doesn’t in terms of banking relationships, lending, financing, administrative work and your time or team in place to help with everything. As a rule of thumb, never move forward with someone who tells you to put your real estate in an S-Corporation because they do not have your best interests in mind.
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