At Cerebral Tax Advisors, we have often found that medical professionals love to invest in real estate since it is an excellent way to generate a return on investment, diversify your portfolio, and take advantage of tax write-offs. At first glance, it might seem advantageous to do so through an S-Corporation (S-Corp)—a structure known for its tax benefits and liability protection. However, owning real estate in an S-Corp can lead to significant challenges and pitfalls.
In this guide, we’ll explore why holding real estate in an S-Corp may not be the best decision and offer alternatives that may be a better fit.
The basics of owning real estate in a corporation
S-Corporations and C-Corporations (C-Corps) provide liability protection for shareholders. However, their tax mechanics differ.
- S-Corporations allow income and losses to pass through to shareholders, avoiding double taxation. They’re limited to 100 shareholders and can only issue one class of stock.
- C-Corporations face double taxation, where the corporation pays taxes on its earnings and shareholders pay taxes on dividends. However, C-Corps can have an unlimited number of shareholders and multiple classes of stock.
The appeal of corporations
Structuring your business or holding company as a corporation can offer several benefits. Let’s review those benefits to understand why it might seem like a good structure for your real estate business.
- Liability protection. S-Corps and C-Corps provide liability protection, shielding personal assets from business liabilities. This is particularly appealing for real estate investments, where there’s a risk of lawsuits and other liabilities.
- Centralized management. Corporations offer a centralized management structure, which can simplify decision-making processes for businesses owning multiple properties or engaging in complex real estate transactions.
- Ease of transferability. A corporate structure makes it easy to transfer ownership interests through the sale of stock. This can be helpful if you want to sell a business or bring in new investors.
- Access to capital. Corporations, particularly C-Corps, can issue stock to raise capital, which can be beneficial for funding real estate acquisitions and developments.
- Tax savings. Corporations pay federal income taxes at a flat rate of 21%, which is significantly lower than the highest individual income tax bracket of 37%. Operating an S-Corp can reduce self-employment taxes for owners because they only owe self-employment tax on their salary—not 100% of the business’s net income.
Despite these perceived benefits, owning real estate in a corporation can lead to significant tax and financial complications.
Owning real estate in a corporation: Understanding S-Corps debt basis limitations
Owning real estate in a corporation, especially an S-Corporation, can lead to complex tax implications that often outweigh the perceived benefits.
One of the primary issues with holding real estate in an S-Corp is the limitation on the shareholder’s debt basis. In an S-Corporation, a shareholder’s ability to deduct losses is limited to their stock basis plus any direct loans they’ve made to the corporation. Unlike partnerships or LLCs, shareholders cannot increase their basis by their share of the entity’s debt. This limitation restricts their ability to deduct losses from the real estate investment.
Transferring rental real estate into a corporation
Purchasing rental real estate in an S-Corporation isn’t a problem on its own, but transferring it into an S-Corporation may be taxable.
When transferring real estate into a corporation, the Internal Revenue Service (IRS) treats the transaction as a sale. This means any appreciation in the property’s value since its original purchase could be subject to capital gains tax. The corporation is considered to have “purchased” the property at its current market value, triggering a taxable gain for the transferring party.
For example, say you own a commercial building and want to bring in partners to renovate and rent it out. You form an S-Corporation with those partners, with you contributing the property and your partners contributing cash for renovations.
Unfortunately, you’ll have to pay capital gains taxes from transferring appreciated real estate into a corporation.
An exception allows you to transfer real estate into a corporation without recognizing a capital gain. To qualify for this exception, you must own 80% or more of the corporation’s stock immediately after the transfer.
However, even if you qualify for this exception, there’s a good reason not to transfer property into a corporation: getting it out will also have tax consequences.
Challenges in extracting real estate assets out of a corporation
Let’s assume you didn’t have good tax advice and purchased or transferred rental real estate into a corporation. Let’s look at three scenarios: selling the property, transferring the property out of the corporation, and passing the property on to your heirs.
Selling the property
The tax consequences of selling the property depend on the business structure.
- S-Corps. In an S-Corporation structure, the gain from the sale is passed through to the shareholders, who must report it on their personal tax returns. This can result in a significant tax liability, especially if the property has appreciated considerably in value.
- C-Corps. In a C-Corporation, the gain is taxed at the corporate level, currently at a flat rate of 21%. However, the proceeds from the sale are still in the corporation. To get it out, shareholders need to take a distribution/dividend, which is also taxable income. So, in effect, the proceeds are being taxed twice, once at the corporate level and again at the individual level.
Transferring the property
What if you want to transfer the property from the corporation instead of selling it? That’s not simple, either. When real estate is distributed from a corporation to its shareholders, the IRS often treats this transaction as a deemed sale, meaning the corporation is considered to have sold the property at its fair market value, which can result in a capital gain.
The tax consequences depend on whether the transfer is a liquidating or a non-liquidating distribution.
In a liquidating distribution, the corporation ceases to exist after the distribution. The corporation has to treat the transfer as if the property was sold and pay taxes on the resulting gain. The owners also recognize a gain on the difference between the fair market value (FMV) of the property received less liabilities assumed by the owner and the owner’s basis in the corporation’s shares.
In a non-liquidating distribution, the corporation is still operating after the distribution. In this case, the corporation treats the transfer as if it sold the property at its FMV and must pay corporate taxes on the capital gain.
Leaving the property to heirs
When you transfer property into a corporation, you lose the step-up in basis at death. Corporations don’t die, so there’s no step-up in basis. In other words, your heirs inherit the corporation’s stock rather than the property itself.
This means they inherit your basis and potentially face a hefty tax bill when they eventually sell the property.
Alternative to an S-Corp for real estate
Hopefully, you now understand why owning rental property in a corporation is not a good idea. While you can own property as a sole proprietorship or in a partnership, a limited liability company (LLC) is generally a better option.
LLCs, like S-Corps, benefit from pass-through taxation. This means the LLC’s income, losses, deductions, and credits pass through to its members, who report these items on their individual tax returns. This allows the owners to avoid double taxation issues faced by C-Corps.
LLCs also provide limited personal liability protection to their members, similar to a corporation. This means that the member’s personal assets are generally protected from the LLC’s debts and liabilities, offering peace of mind while still allowing for the advantages of pass-through taxation.
A significant advantage of LLCs over S-Corporation status is the ability to include a member’s share of the LLC’s debt in their basis. Members can deduct losses up to their investment plus their share of the LLC’s debt, providing greater flexibility in tax planning and loss utilization.
An LLC business structure also offers more straightforward methods for distributing profits and assets to its members without triggering significant tax events. LLCs can distribute profits in a manner that suits the business’s needs and the members’ agreements without the rigid requirements of an S-Corporation.
Distributing real estate or other assets from an LLC typically doesn’t result in the same tax consequences as distributions from a corporation. This makes it easier to move assets in and out of the LLC without incurring prohibitive tax liabilities.
LLCs also offer estate planning benefits that aren’t available to corporations. Members can transfer their ownership interests through gifting or inheritance without triggering tax events. This can simplify estate planning and ensure the smooth transition of assets to heirs.
Get help structuring your real estate business from a trusted advisor
Generally, it’s always better for real estate investors to own a rental building in an LLC rather than an S-Corp or C-Corp. However, remember that LLCs can opt to be taxed like S-Corps or C-Corps, in which case they lose all the aforementioned tax advantages.
Before purchasing or transferring property to any business structure, it’s a good idea to discuss your options with a trusted professional at Cerebral Tax Advisors. We can help you carefully consider your legal business structure and tax classification and devise a tax strategy that fits your unique circumstances and goals.
Schedule a free Tax Discovery Session to save yourself a lot of frustration and surprise tax bills down the line.