At first glance, the benefits that come with an S corporation structure may make it seem optimal for holding real estate. That is not always the case, though. Read on to learn what you need to know before you go that route.

The Appeal of S Corporations

S corporations offer several advantages over other entity structures. For example, S corporations are pass-through entities, meaning the income, loss, deductions, and credits “pass through” to the shareholder. As such, they are not subject to the double taxation imposed on C corporations. Where C corporations are taxed at both the corporate and individual shareholder levels, S corporations are taxed only at the shareholder level.

S corporations also can reduce the tax liability for their owners by reducing their self-employment taxes, which can ring in as high as 15.3 percent for self-employed individuals. The owners are subject to these taxes only on their salary income — not profit distributions.

The benefits of S corps are not just tax-related, though. Corporations in general also protect shareholders’ personal assets from liabilities associated with the business.

These attributes are understandably appealing to real estate businesses and investors. But they also must take into account some potential drawbacks.

The Loss of Basis Step-Up

Heirs generally benefit from what is known as “stepped-up basis” when they receive assets from a decedent’s estate. It changes an asset’s tax basis from the decedent’s basis (typically, the purchase price with some adjustments) to its fair market value (FMV) on the date the decedent died or on an “alternate valuation” date six months following the death. The step-up in basis can translate to substantial savings in capital gains taxes when the heir later sells the asset because the heir will not be taxed on the appreciation that occurred during the decedent’s lifetime.

Transferring real estate into an S corporation forfeits the step-up in basis in the property at death. A shareholder’s designated beneficiaries inherit shares in the corporation, rather than interests in the assets the corporation holds — so the step-up in basis applies to the shares, not the assets. Upon sale of real estate in an S corp, then, all of the appreciation will be taxable, not just the post-death appreciation. This is an important consideration for families that intend to leave real estate to younger generations.

Partnerships and limited liability companies (LLCs), on the other hand, can make a so-called Sec. 754 election. The election allows them to step-up the basis in their assets to the FMV on the date of the death of an owner or the transfer of an ownership interest.

Difficulties When Transferring Appreciated Property

An S-corp structure also can lead to hefty tax bills when appreciated real estate is moved in and out of it. For example, transfers of appreciated property to an S corp are subject to capital gains tax for the transferor-shareholder if it owns less than 80 percent of the majority vote and value in the business after the transfer.

Conversely, when an S corporation distributes appreciated real estate to a shareholder, the distribution may be treated as a deemed sale to the shareholder at FMV. If the FMV exceeds the property’s adjusted basis, the excess is taxable gain. And the gain is passed through to all of the shareholders, based on their share ownership percentage.

Partnerships and LLCs do not have these problems. They can accept or distribute real estate without triggering immediate tax liability.     

The Lack of Debt Basis

An S-corp structure also can restrict the ability to deduct losses, too. Deductible business losses generally are limited to an owner’s adjusted basis in the entity (losses that exceed adjusted basis may be carried forwarded indefinitely).

In an S corporation, a shareholder’s basis equals their stock basis plus their debt basis, which is limited to the amount of direct loans they have made to the business. The only way to increase the debt basis — and, in turn, the amount of businesses losses deductible in the immediate tax year — is to loan the business funds.

By contrast, the basis of the owner of a partnership or LLC equals the adjusted basis of property contributed to the business and the owner’s share of liabilities. A greater share of the business’s liabilities, such as a mortgage on the property, can increase the basis and the allowable deduction for losses.

Explore Your Options

The optimal entity for holding real estate — whether an S corporation, partnership, or LLC — will depend on several factors, tax-related and otherwise. Consult with your financial advisor before making any decisions.

If you have any questions or concerns, please contact your ORBA Advisor or Kaleb Spreitzer at [email protected] or (312) 670-7444 to review your personal tax situation. Sign up here to receive our blogs, newsletters and Client Alerts.