Should you use an S-Corp for real estate rentals?
Maybe. As with so many things, the correct answer depends on the circumstances.
Owning real estate in an S Corporation is not a problem in and of itself. The potential issues could arise when you transfer real estate out of the S Corp.
Before we go any further, let’s first clarify tax and legal classification issues. As noted in earlier posts, S Corporation is a tax classification which can apply to different legal entities. For example, an LLC is a type of legal entity formed under state law. If I tell you that I have an LLC, I have told you nothing about the tax profile of my entity, since we know that an LLC can be taxed as a pass-through entity, as an S-Corp or as a partnership (there may be other options as well, please ask your accountant). Likewise, if I form a corporation under state law, I can elect to have that entity taxed as a C-Corporation or an S-Corporation. So as we are talking about S Corporations in this post, please keep in mind that we are speaking about the tax profile of a given legal entity, whether that entity is an LLC or a corporation.
Ok, with that out of the way, let’s get back to this idea of owning rental real estate properties in an S-Corporation and why that might be a mistake. If you plan to own and hold your real estate rentals in your S-Corp until the end of time, or at least for many years, you might not be overly concerned about this issue. As we know, tax rules and regulations are always changing and the rules applicable to S-Corporations today may be revised forty or fifty years from now. But in my experience, few real estate investors hold their properties for such a long period. Instead, most buy and sell properties with some frequency.
Let’s say our hypothetical real estate investor, Jim, owns a single family home via his LLC which has elected to be taxed as an S-Corp. Jim purchased the property four years ago for $200,000, and the current value of the home is now $400,000 (he bought in just the right area at the bottom of the real estate market). Sounds great so far, right? However, when Jim decides that he wants to make this property his residence, live it for at least the next few years (since it is such a good neighborhood), he is met with a rude awakening.
Jim’s accountant tells him that when he transfers the property from his S-Corp into his name, he will be required to recognize this transaction as a “sale” and pay capital gains tax on the $200,000 “gain.” Is that right? Is Jim required to report this transfer from his single-member LLC (he is the sole member) to himself as a sale? What the #$%#? Well, as strange and nonsensical as that seems, those are the current IRS regulations, and Jim is very unhappy to learn the same. By the way, the result would be the same if instead of putting the home in his name, Jim wanted to gift the property to his widowed mother or his favorite sibling. In making such a gift from the S-Corp to his family member, Jim would be required to recognize a similar “gain” and pay taxes on such a transaction.
If Jim happened to have other co-owners in his S-Corp, the situation would have been even worse, as each of the other members of the S-Corp would be required to recognize a pro-rata share of the “gain” (i.e. their pro-rata of the $200,000) and pay taxes on such deemed gain. Therefore, please remember that if you have any possible plans of eventually removing the real estate from the S-Corp and putting in your name, in the name of a family member or otherwise doing something other than an outright sale to a third party, you likely will want to avoid putting the property into the S-Corp in the first instance.
In conclusion, it should be noted that in situations where real estate is being sold outright to an unrelated third party, these issues are likely not relevant. This is because when there is a sale to an unrelated third party, capital gains recognized on such a sale would be reported (and associated capital gains taxes paid) in the normal course of business. So again, this S-Corp “problem” is most relevant where real estate is removed from an S-Corp for reasons other than outright sale to an unrelated third party. The reason why it is worth noting and remembering is that when applicable, these S-Corp/real estate rules can force a party to come up with significant cash to pay capital gains taxes in situations where there was no actual capital gain/sale.