As real estate investors, structuring your business properly is crucial to optimizing tax benefits, ensuring flexibility, and protecting assets. One common entity used for business owners is the S-Corporation (S-Corp). However, when it comes to rental properties, using an S-Corp can have significant downsides. Today, we will focus on the most critical reason you should reconsider using an S-Corp for your rental properties: removing a rental property from an S-Corp can trigger a major tax event.
The Costly Consequences of Removing Property from an S-Corp
Removing a rental property from an S-Corp isn’t always as simple as just transferring a title. It can inadvertently trigger a “sale” of the property for tax purposes, resulting in unexpected and potentially enormous tax liabilities.
Imagine a situation where you bought a rental property for $500,000, and over time, it appreciated to $1,200,000. If you decide to move the property out of the S-Corp—for reasons such as refinancing, asset protection, or estate planning—this transaction is treated as a taxable event. Essentially, the IRS views this as though you “sold” the property for its fair market value, even if you’re merely moving it to a different entity you control. The result? A $700,000 capital gain that you would be liable to pay taxes on, even though there was no actual cash sale.
Why You Might Need to Remove the Property from an S-Corp
The need to remove a property from an S-Corp can arise for a number of reasons:
- Asset Protection: As your real estate portfolio grows, you may decide to segregate properties into different entities to better protect yourself against liabilities associated with any single property.
- Refinancing: Some lenders may not provide financing or refinancing options for properties held in S-Corps, especially since S-Corps often complicate the mortgage underwriting process.
- Estate Planning: When estate planning, it might make sense to transfer properties into a family trust or distribute properties among heirs. An S-Corp structure makes such transfers more complex and costly, especially in terms of tax consequences.
- Partnership or Business Restructuring: You might want to bring in new partners or change ownership arrangements. Again, the S-Corp structure poses obstacles, as transferring ownership interests is fraught with potential tax issues.
If your property has appreciated significantly, removing it from the S-Corp will almost certainly lead to a substantial tax bill. This is a result that catches many real estate investors off guard, and I’ve seen it happen to multiple clients. It’s a painful and expensive lesson to learn.
S-Corps and Rental Income: A Misalignment in Tax Strategy
Another key reason S-Corps are not ideal for holding rental properties is that they do not align well with the passive nature of rental income. Here’s why:
- S-Corp Shareholder Requirements: An S-Corp allows only a limited number of shareholders, and only individuals, estates, or certain trusts can be shareholders. This limitation may not be practical for those looking to pass real estate to multiple heirs or those wishing to use flexible structures for holding investments.
- Limitations on Distribution of Appreciated Property: The tax issue mentioned earlier occurs because an S-Corp does not allow for the distribution of appreciated property to shareholders without triggering a tax event. The act of moving the property out of the S-Corp is considered a taxable distribution, resulting in taxable gain at fair market value.
- No Step-Up in Basis: One of the major advantages of owning rental property individually or through an LLC is the ability to take advantage of a step-up in basis at death. When someone passes away, their heirs inherit property with an updated basis equal to its fair market value at the date of death, minimizing potential capital gains taxes. An S-Corp structure can make this benefit harder to achieve effectively.
What Entity Structure Works Best for Rental Properties?
If an S-Corp is problematic for holding rental real estate, what should you use instead? Generally, the most appropriate structure for rental properties is either a Single-Member LLC (SMLLC) or a Multi-Member LLC (MMLLC), taxed as a partnership.
1. Single-Member LLC (SMLLC)
- Tax Simplicity: A Single-Member LLC is a disregarded entity for tax purposes, meaning it doesn’t file a separate tax return. Instead, the income and expenses of the rental property are reported directly on your personal tax return (usually via Schedule E). This keeps things simple and reduces your compliance costs.
- Flexibility: Moving property in or out of an LLC doesn’t typically trigger a taxable event. You have more flexibility to restructure or refinance without facing significant tax consequences.
- Asset Protection: An LLC provides some level of asset protection, limiting personal liability if there are lawsuits or debts tied to the rental property.
2. Multi-Member LLC (MMLLC) Taxed as a Partnership
- Flexibility for Multiple Owners: If you own properties with partners, an MMLLC is often the best choice. This type of entity allows flexibility in profit distribution, as members can determine their share of the income, loss, and capital gains.
- Tax Advantages: Unlike an S-Corp, an MMLLC taxed as a partnership can allocate income and losses differently from ownership percentages, allowing for more creative tax planning. Moreover, partnerships avoid the double-taxation problem that occurs with C-Corps, and MMLLCs allow you to contribute and withdraw properties without triggering an immediate tax event.
- Step-Up in Basis: When a partner in an MMLLC passes away, the partnership structure can allow for a step-up in basis for the deceased partner’s share of the property, which can be a significant tax advantage for the heirs.
Depreciation Recapture and S-Corps
Another complication arises with depreciation recapture. Rental property owners can take a depreciation deduction annually to account for the wear and tear of the property. While this is a significant tax benefit during ownership, it leads to depreciation recapture upon sale. The problem with an S-Corp is that, when you remove a property and trigger a deemed sale, you not only recognize capital gain on the appreciation but also depreciation recapture, which is taxed at higher ordinary income rates.
When Might an S-Corp Be Useful?
To be fair, an S-Corp has its uses, primarily for active businesses where avoiding self-employment tax is important. For example, if you are actively engaged in property flipping or running a real estate brokerage, an S-Corp may help you reduce self-employment taxes on the income you draw as a salary.
However, rental properties are considered passive activities for tax purposes, meaning self-employment tax generally doesn’t apply to rental income. Using an S-Corp for rental income could therefore be overcomplicating matters without any significant tax savings.
The Bottom Line: Avoiding Costly Mistakes with Your Rentals
Choosing the right entity structure for your real estate investments is critical. While the allure of an S-Corp might make sense for other types of businesses, rental property investors must carefully consider the implications. The main takeaway is that using an S-Corp to hold rental properties can lead to significant tax consequences, particularly when it comes to removing property from the S-Corp.
If you already own rental property through an S-Corp, all hope is not lost. It’s worth discussing your options with an experienced real estate tax advisor who can help you determine the best path forward, potentially mitigating exposure to capital gains taxes and strategizing for future growth.
For most investors, forming a Single-Member LLC or a Multi-Member LLC taxed as a partnership is a better approach that allows flexibility, reduces the risk of triggering taxable events, and simplifies the management of your real estate portfolio.
At Cardinal Tax, we specialize in helping real estate investors navigate these complexities to optimize their tax situation. If you’re unsure whether your current structure is the most effective for your rental business, reach out to us today. Let’s make sure you’re building your wealth efficiently—and without unpleasant surprises.